Its a Wrap

Well, its time. Time to burst out of this blog bubble here and see what the real world offers.

In other words, The Daily Options Report has officially run its course. I believe I was the first one exclusively in the options space when I started, now there’s a bunch of excellent ones.

We posted maybe 14,000 times about the VIX, cheesily used VIX bikini shots and thrown “Erin Burnett” and “naked put sales” into the same article to fool the Search bots. While the world was running Lenny Dykstra hagiography’s, we were all over the fraud.

I hope you learned a thing or two about options. And I really hope you bought my book.

I really appreciate all the kind words over the years. And hey, I’m not going away, you can still find me on twitter (I’m @agwarner) on InvestorPlace and on a new venue To Be Named Later ( I haven’t started yet).

So, to quote Truman Burbank, “Good morning, and in case I don’t see ya, good afternoon, good evening, and good night!”

SKEW And You

Tired of laboring comparing two numbers on an SPX options board and dividing one by another? Fear not, the CBOE will now do it for you! This, from CNBC.

Investors looking for Black Swans in the stock market may be able to find them in the latest offering from the Chicago Board Options Exchange.

On Feb. 23, the CBOE plans to roll out the S&P 500 Skew Index, an options gauge that already has earned the monikers of both the Black Swan Index and, a bit more derisively, the SIX.

At its heart, the SKEW (as the CBOE prefers) will measure out-of-the-money S&P 500 options to determine the risk of unanticipated, or Black Swan, events threatening the market. The Black Swan reference, of course, is from the Nassim N. Taleb book of the same name that, in part, delineates the importance of low-probability but catastrophic events in financial markets.

The SKEW will measure the implied volatility between puts and calls and derive a numeric value from the difference between the two.

Well I guess this will look at more than 2 strikes. But its not going to yield an enormously different result from doing something simple like taking a call premium that’s X% away from the money and dividing it by a put that’s also X% away. Or just looking at a skew chart that’s available on ivolatility or LiveVol.

But whatever, it can’t hurt to have more info indexed in a more accessible format. Its generally going to tell the same story as VIX though. Remember that VIX incorporates all sorts of OTM puts, so looking at SKEW on top of VIX sounds very redundant. If OTM puts are flying, so will VIX.

And also, as my friend notes, “Since the whole point of Taleb’s work is that “Black Swan” events have no probability distribution (i.e., they are one-offs), how can one construct an instrument that attempts to assign such things a probability?”. Of course he’s right, you can’t, though the market will try.


Looks like we got a new group of options coming down the pike from Nasdaq. This, from Brendan Conway at The Journal

The exchange got the nod to list and start trading options on the so-called “Alpha Indexes,” a Securities and Exchange Commission filing late Tuesday shows. The indexes, co-created by the designer of the first VIX “fear gauge,” track popular stocks’ performance versus a broader market benchmark. By listing options, Nasdaq hopes to let investors generate returns even when markets are down, with options that profit when Apple or Citigroup outperforms even a plunging stock market.

“In stock options, you’re actually making two bets. You’re betting that Apple will rise relative to the market, and also that the market will go up,” VIX designer Robert Whaley, now a professor at Vanderbilt University’s Owen Graduate School of Management, told Dow Jones Newswires at the indexes’ October unveiling. “With these, you’re getting a more precise investment in something you have some knowledge about.”

The Alpha Indices let you make a bet on one product vs. another, but with just one trade. In other words, lets say you want to capture the return of Apple over SPY…..well, you’re in luck, there’s AVSPY. And given the bull market in AAPL, you’ve done quite well with that one. Not quite so much with the other 3 that go against SPY. There’s EEM (EVSPY), TLT (TVSPY) and GLD (GVSPY). And for good measure, there’s a play on C vs. XLF (CVXLF).

Not sure I totally see the demand to play C vs. financials, but the others do have some appeal imho. Obviously you can construct any of these on your own. And in any form you want. You can go long AAPL calls vs. short SPY, long AAPL calls vs, short SPY calls, long AAPL puts vs. SPY puts, or…….you get the idea. The “Alpha” Index itself gets you essentially long one stock vs. short the other. If you want an option play, it clearly makes life easier to use “Alpha” options. If you use calls (or puts) on both, you not only have bet on direction, you’ve also bet on the relationship of volatility of one to the other. So an “alpha” bet adds a layer of simplicity.

The catch? Well, who knows the liquidity. I can’t imagine they catch fire so fast. These “alpha’s” are just indices now, and rather ignored ones. Letting the world trade them will generate some attention. But how much, we don’t know.

Also, they’re European exercise and cash settled, for the obvious reason that there’s nothing to deliver just yet. That works fine sometimes, well at least until you start getting the big players in messing with settlement prices. The plus side though is that an index base will not have the inevitable problems that an ETF or ETN will encounter. Such as fees, and problems tracking the underlying.

All in all I find this a very interesting idea. Not sure I’d go trade these so fast though. Wait and see if they get some traction.

AAPL Volatility Droppings

Got some thoughts on AAPL options over at Investor Place. Nickel version is that they’re kind of cheap. Dime version is that its not that simple. Quarter version is…..please click thru.

Half dollar version is…..I’m sorry, Black Eyed Peas are awful. I flip around like 3-4 stations on Sirius, none of which play anything from them, yet I’ve heard “I’ve Got a Feeling” 42,000 times in my life. Here’s my realistic suggestions for next year. Green Day or Pearl Jam.

Happy VIX Days From Here

happydays Happy VIX Days From Here

This, from MKM Partners

A defining characteristic of equity implied volatility is its tendency to mean revert. With the CBOE SPX Volatility Index (VIX, 15.93) having been sustained below 20 for more than two months, we believe reversion through the long-term mean is inevitable. As a result, we see short-term risk as becoming increasingly asymmetric and continue to recommend that favorable option market dynamics be exploited.

Spot VIX declined through 20 on December 2, 2011, and at that time we argued that the displacement of VIX to 45 earlier in 2010 coupled with a two-month consolidative phase between October and November would apply significant downward force into the volatility wave trough. Our expectation at the time was that VIX would be sustained under 20 for around two months and trough close to the bottom of the 15-18 range that had been established beginning in July 2007, while the S&P 500 Index gained in the neighborhood of 10% based on the precedent of the March-April 2010 period.

As the two-month anniversary of VIX being sustained under 20 approached, we discussed on January 18 our view that the criteria for a wave trough had been met and suggested that, within our framework, this equated to an increasing state of disequilibrium for U.S. equity markets. As a result, we recommended that favorable volatility dynamics – namely low implied volatility and flat skew – be exploited to reduce risk following what was then a 23% appreciation of the SPX from the August 2010 low. Over the subsequent two weeks, VIX ran up sharply to just above 20 on news of unrest in Egypt, then rolled over to close Friday just below the 16 level while the SPX managed to grind another 1.2% higher.

Then, last week, sub-20 readings for spot VIX surpassed the March-April 2010 period and all prior troughs since the current high-volatility regime began in July 2007. Naturally, this has prompted questions about any change to our view. For example, some wondered if unprecedented U.S. monetary policy has distorted the current volatility cycle, shortening it relative to the 5.5-year average duration of regimes over the last 30 years. In our view, this is unlikely. We think it as improbable that the aftermath of the global financial crisis and deep U.S. recession is more psychologically benign than recovery periods following what were relatively shallow economic troughs in March 1991 and November 2001.

As a result, our base case remains that the current high-volatility cycle returns to its July 2007-August 2008 pattern when spot VIX was bound between 15 and 30, an outcome that may feel somewhat moderate relative to the volatility events over the last two years. Still, if our framework holds, implied volatility will revert through its long-term mean just above 20, coincident with a pullback in the U.S. equity market. Following a 25% gain in SPX since late August 2010, unrealized gains abound. Low implied volatility and flat skew afford the opportunity to hedge these gains or replicate long exposure synthetically using options to reduce risk. With the next volatility event still on the horizon, in our view, this is not a time to accept complacency.

I would agree that we’re a bit overdue for a volatility *correction*. And I currently pay decay, first time I’ve had that on in eons. I’m net long options gamma in a handful of individual names and not short enough index options premium to offset it. But (big but)….its VERY tough to time a volatility explosion. You generally get one or two per year. Our last big one was in May, and we’ve had pretty modest and quick one’s in November and a couple weeks ago. That being said, there’s no magic time frame for the next one, and no magic VIX low that will ignite it.

So don’t get carried away anticipating it. Time costs money in options world.

Stats and Selection Bias

If there’s one thing I learned writing a book, its that you can make stats say what you want if you’re so inclined.

OK, that’s not true, I was well aware of that years ago. Its a very real trap though when it comes to trading. We naturally tend to highlight, link to, and trade off data that confirms our pre-existing opinions. Actually, we do that in every walk of life, so why wouldn’t we transfer that to trading? If I have a thesis that stock XYZ is headed to 0, I will naturally highlight confirming data, and ignore disputing data, and may not even realize I did so.

The baseball site Fangraphs has some great stats-minds if you’re into that sort of geekery. But they’re far from immune to succumbing to pre-existing biases. In a way they’re actually worse. Its almost like LTCM knowing so much about bond arbs that they bet themselves into bankrupcy waiting for that elusive mean reversion. Here’s a post on Matt Cain.

To quickly fill-in, Cain is the battlefield for stats vs. observation. The stats community believe his true talent level lies below his actual (very good) performance. Why? Mainly a disproportional number of fly balls he gives up stay in the park. Every year of his career. So they debate whether that’s a skill or an fluke that will ultimately mean revert.

Any time a general theory that applies to most people is advanced, people naturally begin to look for the outliers, and they often use the examples at the ends of the spectrum to cast validity on the theory. Or, they just dismiss the theory as not being applicable to that specific case, which may or may not be true. We see this quite a bit with metrics like xFIP and Matt Cain, who has become the poster child for the part of our readership who thinks that stat isn’t worth all that much. For years, Cain’s ERA has been better than his xFIP would suggest, largely because he has sustained one of the lowest HR/FB rates in all of baseball.

The low HR/FB rate was brought up again yesterday in a reasoned post over at PaapFly. As is often stated by the Cain-is-better-than-xFIP-says crowd, the author noted that Cain has thrown 1,100 innings in the big leagues now, and that should be a large enough sample to conclude that this is a legitimate skill that he can carry forward.

Just for fun, I decided to look back at the data that has been collected over the last nine years. We’re starting to get large enough samples now where we can find other pitchers who have had similar stretches of home run prevention for 1,000+ innings, and still have observed performance in seasons after their run of keeping the ball in the park.

Below are 10 pitchers who, from 2002 to 2007, had the lowest HR/FB rates in baseball, who have thrown a similar number of innings to Cain, and have thrown at least 100 total innings in the last three seasons. The first section is their 2002-2007 IP and HR/FB rate, with the second section being their 2008-2010 IP and HR/FB rate.

Pedro Martinez: 981 IP, 8.0% HR/FB – 154 IP, 14.2% HR/FB
Roy Oswalt: 1,272 IP, 8.3% HR/FB – 602 IP, 10.4% HR/RB
John Lackey: 1,162 IP, 8.5% HR/FB – 555 IP, 10.5% HR/FB
CC Sabathia: 1,226 IP, 8.5% HR/FB – 721 IP, 8.2% HR/FB
Brad Penny: 1,041 IP, 8.7% HR/FB – 324 IP, 10.5% HR/FB
Jarrod Washburn: 1,121 IP, 8.7% HR/FB – 330 IP, 9.3% HR/FB
Barry Zito: 1,320 IP, 8.8% HR/FB – 571 IP, 7.9% HR/FB
Miguel Batista: 1,051 IP, 8.8% HR/FB – 269 IP, 11.7% HR/FB
Dontrelle Willis: 1,022 IP, 8.9% HR/FB – 123 IP, 11.5% HR/FB
Kevin Millwood: 1,160 IP, 9.1% HR/FB – 558 IP, 10.6% HR/FB

Group: 11,351 IP, 8.6% HR/FB – 4,202 IP, 9.9% HR/FB

The league average HR/FB rate is usually around 10.6%. As a group, the ten best big time home run suppressors from 2002 to 2007 were only marginally better than average at that same skill from 2008 to 2010. Sabathia and Zito bucked the trend and actually lowered their HR/FB rates over the last three seasons, so it’s certainly possible that Cain could continue to post low HR/FB rates going forward. After all, he does pitch in a pretty good pitcher’s park and his career HR/FB rate is better than any of the pitchers in this sample, so maybe there is something to David Pinto’s theory about how his fastball moves.

You could have made a similar argument about almost everyone on the above list, though, and as a group, they didn’t demonstrate that there was really much of a sustainable skillset there.

xFIP is their definition of *real* ERA, basically assuming normal numbers of balls in play of each type (grounders,flies, etc.) turn into hits, normal number of flies are homers, and so on.

It all sounds great, right? Matt Cain is straight out of Fooled by Randomness. Except the writer has a major #fail here, he implicitly assumes every pitcher has an identical skill set in the 2002-2007 period as he does for the 2008-2010 period.  So let’s say “for kicks” we make a very minor attempt to control for skill level.

In other words, here’s the thesis. If ability to keep flies in the park is a skill for this tiny sample set, it should correlate with other skills. Like ability to strike out batters, or the ability to avoid walks. Or best of all, the ratio of strikeouts to walks (K/BB).

And guess what, the overall skill level of the above 10 pitchers deteriorated in the later period. From 2002-2007, they combined to strike out 6.84 batters per 9 innings (K/9), while walking 2.81 per 9 (BB/9) for a K/BB ratio of 2.43. That’s an excellent ratio btw, so as a group these are elite pitchers. Fast forward to 2008 and the numbers drop to 6.72 K/9, 3.20 BB/9 and 2.10 K/BB.

Only 3 of the 10 pitchers improved their K/BB in the later period, Oswalt, Lackey and Sabathia. But Sabathia improved in his ability to keep flies in the park too, so its actually consistent with viewing that as a skill (pro Cain ability). Lackey’s K/BB nudged up from 2.63 to 2.67, and Oswalt was basically flat, 3.43 to 3.44. We should also note that Zito saw his K/BB drop from 1.82 to 1.58, so that’s inconsistent with his improvement in keeping flies in the park.

So what we have here are 6 pitchers whose ability to avoid giving up homers deteriorated with their ability to control the strike zone in general, and a 7th (Sabathia) whose got better at both. And all 7 showed significant changes in K/BB. On the flip side, we have Oswalt and Lackey barely budging in *skill* and simply allowing more homers, and Zito allowing fewer homers while his *skill* level eroded.

I don’t believe any of this proves that HR/FB is a skill, but it certainly suggests there’s some ability attached to it. It certainly refutes the author’s take on it.