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MONEY
MANAGEMENT
by
Lawrence G. McMillan
Measuring
And Trading Volatility
Reprinted
from a composition of several articles in The
Option Strategist newsletter, as excerpted from the
forthcoming 4th edition of the book, Options
As A Strategic Investment, by
Lawrence G. McMillan, President, McMillan Analysis Corp.
The
one thing that ties all option strategies together and allows one to
make comparative decisions is volatility. In fact, volatility
is the most important concept in option trading. Oh, sure, if you're
a great picker of stocks, then you might be able to get by
without considering volatility. Even then, though, you'd be
operating without full consideration of the main factor influencing
option prices and strategy. For the rest of us, it is mandatory that
we consider volatility carefully before deciding what strategy to
use.
The
information to be presented here is not overly theoretical.
All of the concepts should be able to be understood by most option
traders. Whether or not one chooses to actually "trade
volatility", it is nevertheless important for an option trader to
understand the concepts that underlie the basic principles of
volatility trading.
Why
Trade "The Market"?
The "game" of stock market predicting holds appeal for many
because one who can do it seems powerful and intelligent. Everyone
has his favorite indicators, analysis techniques, or "black box"
trading systems. But can the market really be predicted? And if it
can't, what does that say about the time spent trying to predict it?
The answers to these questions are not clear, and even if one were
to prove that the market can't be predicted, most traders would
refuse to believe it anyway. In fact, there may be more than one way
to "predict" the market, so in a certain sense one has to
qualify exactly what he is talking about before it can be determined
if the market can be predicted or not.
The
astute option trader knows that market prediction falls into two
categories: 1) the prediction of the short-term movement of prices,
and 2) the prediction of volatility of the underlying. These are not
independent predictions. For example, anyone who is using a
"target" is trying to predict both. That's pretty hard.
Not only do you have to be right about the direction of prices, but
you also have to be able to predict how volatile the underlying is
going to be so that you can set a reasonable target. In certain
cases, the first prediction can be made with some degree of
accuracy, but the second one is extremely difficult.
Nearly
every trader uses something to aid him in determining what to
buy and when to buy it. Many of these techniques, especially if they
are refined to a trading system, seem worthwhile. In that
sense, it appears that the market can be predicted. However,
this type of predicting usually involves a lot of work, including
not only the initial selection of the position, but money management
in determining position size, risk management in placing and
watching (trailing) stops, etc. Thus, it's not easy.
To
make matters even worse, most mathematical studies have shown that
the market can't really be predicted. They tend to imply that anyone
who is outperforming an index fund is merely "hot" - has hit a
stream of winners. Can this possibly be true? Consider this example.
Have you ever gone to Las Vegas and had a winning day? How about a
weekend? What about a week? You might be able to answer Ayes" to all
of those, even though you know for a certainty that the
casino odds are mathematically stacked against you. What if the
question were extended to your lifetime? Are you ahead of the
casinos for your entire life? This answer is most certainly
"no" if you have played for any reasonably long period of time.
Mathematicians
have tended to believe that outperforming the broad stock market is
just about the same as beating the casinos in Las Vegas possible
in the short term, but virtually impossible in the long term. Thus,
when mathematicians say that the stock market can't be predicted,
they are talking about consistently beating the "index" - say,
the S&P 500 over a long period of time.
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Those
with an opposing viewpoint, however, say that the market can be
beat. That the "game" is more like poker where a good player
can be a consistent winner through money management techniques than like casino gambling, where the odds are fixed. It would be
impossible to get everyone to agree for sure on who is right. There's
some credibility in both viewpoints, but just as it's very hard to
be a good poker player, so it is difficult to beat the market
consistently with directional strategies. Moreover, even the best
directional traders know that there are large swings or drawdowns in
one's net worth during the year. Thus, the consistency of
returns is generally erratic for the directional trader.
This
inconsistency of returns, the amount of work required, and a
necessity to have sufficient capital and to manage it well are all
things that can lead to the demise of a directional trader. As such,
short-term directional trading probably is not really a
"comfortable" trading strategy for most traders and if one is
trading a strategy that he is not comfortable with, he is eventually
going to lose money doing it.
So,
is there a better alternative? Or should one just pack it in, buy
some index funds and forget it? As an option strategist, one should
most certainly feel that there's something better than buying the
index fund. The alternative of volatility trading really offers
significant advantages in terms of the things that make directional
trading difficult. So if one finds that he is able to handle
the rigors of directional trading, then stick with that approach. He
might want to add some volatility trading to your arsenal, though,
just to be safe. However, if one finds that directional trading is
just too time-consuming, or he has trouble utilizing stops properly,
or is constantly getting whipsawed, then it's time to concentrate
more heavily on volatility trading, preferably in the form of
straddle buying.
There
was an extremely interesting comment in an article on chaos theory,
that has some application to volatility trading. I don't expect most
readers to be familiar with that chaos theory of
mathematics/physics. However, anyone should be able to grasp the
general theory, which states that a small change in a seemingly
irrelevant place can have great affects perhaps even chaotic ones later on in time. It applies to many areas of nature and some have
tried to apply it to the stock market as well, especially after the
crash of >87 which didn't seem predictable by any "standard"
branch of mathematics, but did seem possible under chaos theory.
In
the article, it was pointed out that some systems just can't be
predicted. Chaos theory also aids in determining that fact as well.
For example, chaos theory provides some evidence that earthquakes
cannot be predicted. Is this a useful piece of information, or just
some irrelevant trivia? In fact, it is quite useful and important.
The article quotes mathematical physicist Henrik Jensen as saying,
"It's pretty important if you can say you will never be able to
predict earthquakes. Instead you should concentrate on building
quality houses."
I
thought that comment was very apropos to the stock market. If chaos
theory says that we can't predict the stock market and many say
that it does then perhaps we should stop trying to do so and
instead should concentrate on building quality strategies. Such a
strategy would certainly be volatility trading especially straddle
buying when implied volatility is low.
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Volatility
Trading Overview
Volatility trading first attracted mathematically oriented traders
who noticed that the market's prediction of forthcoming volatility (i.e., implied volatility) was substantially out of line with what
one might reasonably expect should happen. Moreover, many of these
traders (market makers, arbitrageurs, and others) had found great
difficulties with keeping a Adelta neutral" position neutral.
Seeking a better way to trade without having a market opinion on the
underlying security, they turned to volatility trading. This is not
to suggest that volatility trading eliminates all market risk turning it all into volatility risk, for example. But it does
suggest that a certain segment of the option trading population can
handle the risk of volatility with more deference and aplomb than
they can handle price risk.
Simply
stated, it seems like a much easier task to predict volatility that
to predict prices. That is said, notwithstanding the great bull
market of the 90's in which every investor who strongly
participated certainly feels that he understands how to
predict prices. Remember not to confuse brains with a bull market.
Consider the chart in Figure 1:
This
seems like it might be a good stock to trade: buy it near the lows
and sell it near the highs, perhaps even selling it short near the
highs and covering when it later declines. It appears to have been
in a trading range for a long time, so that after each purchase or
sale, it returns at least to the mid-point of its trading range and
sometimes even continues on to the other side of the range. There is
no scale on the chart, but that doesn't change the fact that it
appears to be a tradeable entity. In fact, this is a chart of implied
volatility of the options of a major US corporation. It really
doesn't matter which one (it's IBM) for the implied volatility chart
of nearly every stock, index, or futures contract has a similar
pattern - a trading range. The only times that implied volatility
will totally break out of it's "normal" range is if something
material happens to change the fundamentals of the way the stock
moves - a takeover bid, for example, or perhaps a major acquisition
or other dilution of the stock.
So,
many traders observed this pattern and have become adherents of
trying to predict volatility. Notice that if one is able to
isolate volatility, he doesn't care where the stock price goes he
is just concerned with buying volatility near the bottom of the
range and selling it when it gets back to the middle or high of the
range, or vice versa. In real life, it is nearly impossible
for a public customer to be able to isolate volatility so
specifically he will have to pay some attention to the stock
price, but he still is able to establish positions in which the
direction of the stock price is irrelevant to the outcome of the
position. This quality is appealing to many investors who
have repeatedly found it difficult to predict stock prices.
Moreover, an approach such as this should work in both bull and bear
markets.
Despite
the neutral stance, there is risk in volatility trading. For example,
if one decides to "buy" volatility, he will generally be buying
options. Thus, he is at risk of time decay and he also has a risk that
volatility might decrease while the position is in place. On the other
hand, if one decided to sell options as his initial position (because
volatility was "too high")_then he faces other risks: there is the
risk that volatility could increase and thus cause losses, and if the
options are naked options, there is the risk that the underlying instrument
could move sharply a gap move and cause large losses. For this
latter reason, we generally prefer to trade volatility from the long side or
as a spread not with naked options.
Volatility
trading has an appeal to a great number of individuals. Just remember
that, for you personally to engage in a strategy, you must find that it
appeals to your personal philosophy of trading. To try to use a
strategy which you find uncomfortable will only lead to losses and
frustration. So, if this somewhat neutral approach to option trading sounds
interesting to you, then we should talk.
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