Short term Weekend lounge 17th-19th March, page-25

Occasionally I have posted items from my good trading friend in the US, @Diver Dan, who moved 'beyond' Aussie pennies along time ago. I have been enticing him to make us a regular Letter from America, but without avail.

But regardless, here is some personal correspondence that some of you may find interesting. I'm sure he'll be open to queries, so I will let him know if I see any of your tags. Just don't ask me.  

From @Diver Dan

I have been shorting the S&P on a regular basis and it is not easy to do.  Today I noticed some strange things about the VIX and options.  Since options are complex, I use calculators to figure out the probabilities of my trades.  Even with calculators, it is very difficult - comprehending how time and price movement of an underlying stock or the S&P as a whole affects a given option contract is important.  Understanding how the open interest - that is, the contracts owned by options traders - affects the direction the market may take has become very important too.  The reason for this is that a large portion of the daily movement you see in the stock market is determined by option interest.  It is so controlled, in fact, that on options expiration days - now options expire on each Wednesday and Friday of the the week -  the SPY or SPX can pin to within a  penny of the 'best pin' or area where options interest dictates that it should fall to satisfy all involved in the contracts.  Think about that for a moment.  The index that contains 500 of the largest companies in the world can be predicted to pin, with a high degree of accuracy, to within a few cents.  It does not always work of course, but it works better and better lately.  In my opinion, this game is getting thin.

Tomorrow is a big expiration day as Weekly, Monthly, and Quarterly options and futures will expire at the same time. This has historically had ramifications for the stock market.  In the past few years, it has meant a big rally on expiration day, followed by an equally large decline in the days that follow.

But something weird is going on this month.  It has to do with volatility.  Volatility is a thing that options traders must pay attention to.  If a person is short the market by owning put options - he wants the market to go down so that is put options increase in value - he must calculate how volatility will affect the price of his options.  If volatility rises, his put options will grow in value much more than if just the price of the market declines.  It is spikes in volatility - measured by the VIX Volatility Index - that allow options traders to create huge gains in a short amount of time.

Preliminary Tutorial. Take this at face value it is only to introduce terms.

Don't fret if you don't understand this, I barely do myself.  I would have to explain the vary basics for the various models for derivatives for it to make total sense, but the terms used to describe the factors that affect options will be enough.  In a nutshell you have four basic 'Greeks' that control the price of options. Delta - refers to the rate of change of the price of an option relative to the asset it tracks. Theta - refers to the way time itself impacts the price of an option. Gamma - refers to the rate of change of Delta.  The other important Greek is Vega - this represents the way volatility affects the price of an option.  All of these Greeks are changing constantly as time and price of the underlying asset changes. From the very moment you purchase or sell an option, the Greeks start to interact with each other as the factors of time and volatility come into play.  This is because options are based on specific prices to be arrived at by certain dates.

And now on to the discussion.

Well, Volatility has been suppressed lately in a rather unprecedented way.  It is not very often that you see the VIX staying at the low levels for such long periods.  There is a reason for this suppression lately and it has to do with the options position of some very large market players.  Tomorrow, there will be some re balancing.  There is a big open interest in S&P options at 2250, about 130 S&P points below our current position.  There is also an imbalance of something called Gamma - a 'Greek' that measures the rate of change of an options Delta.  Delta as noted is the number used to represent the rate of change of an option vis a vis the underlying investment - in this case, the S&P 500 itself.  The reason there is this Gamma imbalance is because as the market has sold off a bit lately, people have rolled their options out to further expiry dates.  Tomorrow the options - skewed toward the call side - that created this imbalance in Gamma will be sold.  As you may have heard today, this could cause some larger than normal fluctuations next week. Gamma is very sensitive to movements in the price of the underlying asset.  Because volatility is so suppressed, there is a phenomenon that happens when people sell stocks that could result in volatility to spike much higher and faster than usual if sellers were to take control of the market.  Dealers could hedge their positions by buying volatility after they liquidate their options holdings tomorrow, and this could cause the VIX to spike higher.  This could cause a self perpetuating increase in volatility.  This notion is not mine, as JP Morgan has warned that tomorrow, 1.4 Trillion in options will be unwound.

Now to the VIX itself and my own inquiries - tame by comparison to the above.  As I mentioned above, the VIX is low.  It certainly has been this low before but has not stayed this low this long before. Below are two charts that measure market volatility.  Today I noticed that the VVIX, the indice that measures the volatility of the VIX - not kidding - dropped precipitously to a level last reached in May of last year.  I view this as a possible contrary indicator but do not know enough about it to put to much into it.

The first three charts are just the S&P and its proxy the SPY, the last chart is the one that changed quite a bit today.   The last two charts are the ones that I wanted to bring to your attention.

SPY Hourly


S&P Daily

SPY Daily Chart

VIX - CBOE Volatility Index


VVIX - CBOE VIX Volatility Index