tastytrade Options Jive: Recent Episodes
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If you want to trade like a tastytrader, you have to learn how to talk like a tastytrader. Sit down with Tom and Tony as they dish out and discuss popular trading topics that give you an edge when opening, closing and managing your trades.
The simplified Expected Move formula “Stock Price ✕ (IV / 100) ✕ SquareRoot(N / 365)” allows for traders to easily calculate the market’s expectation for a particular stock to move a certain amount over any number of days. Remember, implied volatility is the driver of expected move, so when IV of a stock changes, so will the expected move.
Tom and Tony give an overview of how we can calculate expected move ourselves and how to incorporate into our options trading strategies.
Short premium positions are most profitable in high IV environments, and we trade IVR > 30 as a rule of thumb to ensure this. However, if IVR becomes skewed, there may still be short premium opportunities when IVR < 30. With all the major index ETFs having IVR < 30, is there still room for opportunity? Comparing the current IV with the 10-year average IV for each index, we can see that each market index has the potential for significant IV contraction and profitable short premium opportunities.
Quantifying the overall risk factors of a portfolio becomes more complicated when you begin including options in addition to equities. The Greeks can be used to characterize risk for individual option contracts, as well as the overall risk of multi-contract strategies and option portfolios. Today we discuss an example of how we can calculate overall portfolio Greeks on the tastyworks platform and use them to analyze overall portfolio risk.
Using delta as our strike selection allows us to get a fairly accurate representation of the risk we are taking on relative to the premium we collect.
Over the years, delta has adjusted for the growth in stock price, changes in volatility, and the premium collected. This is what makes it easy to use!
In a market like last week, where one side of a strangle gets tested extremely quickly, we generally have a set of mechanics to defend the position.
We call this “rolling up the untested put” or “rolling down the untested call” depending on which side gets tested.
In this segment, we provide graphics that explain how your positions and profits look like for a strangle when going inverted. Check out the slides to get a cool graphical representation of the process!
Skew is where traders perceive the most risk. For example, for equities, the velocity of risk, and therefore skew, is to the downside because when markets drop, they drop much faster than they rise on average. For commodities, the velocity of risk is to the upside meaning that commodities tend to crash upward much faster than they drop to the downside.
To determine where the risk of a market lies, look at the option chain and pick a delta of a put and call option. At the same delta, if the put is more expensive than the call, then that market exhibits downside risk. If the call is more expensive, the market exhibits upside risk.
Option pricing models require assumptions about stock price dynamics that are not entirely accurate.
For instance, the Black-Scholes model assumes that stock prices follow Geometric Brownian motion, which does not take into account jumps, splits, fat tails, or changes in volatility.
These dependencies result in differences between theoretical option prices and actual option prices, and these differences can be visualized through the implied volatility surface.
Delta measures the probability of an option expiring in the money, but what does this mean for us?
Using delta as our strike selection allows us to get a fairly accurate representation of the risk we are taking on relative to the premium we collect.
Over the years, delta has adjusted for the growth in stock price, changes in volatility, and the premium collected. This is what makes it easy to use!
There is no need to calculate risk/reward metrics such as volatility yourself because delta is an all-in-one solution that allows us to measure risk against reward when entering a trade.
While event probability is essential to traders, it does not take into account related past events that may be relevant. Conditional probability is a way to estimate the likelihood of an event in the context of known information.
Using the conditional probability formula, we look at how often QQQ increases when SPY increases in a very simple example.
Delta represents the change in the option value when the underlying moves up by $1.
For example, an option with a delta of 50 would move by $0.50 when the stock moves up by $1. Similarly, an option with a delta of -50 would lose $0.50 in value when the underlying moves up $1.
Delta can tell us how many shares we are synthetically long or short. For example, an option with 25 delta is the same directional position as being long 25 shares of the underlying.
Tune in as Tom and Tony walk through this greek and why it's such a large component of options trading.
Traditional finance reminds us that it's prudent to diversify our portfolios...that we should never put all of our eggs in one basket. It's good practice to split up our eggs across multiple baskets.
To examine this idea, the research team conducted a study that compared the risk/return profile of a few single stocks versus a portfolio that was evenly allocated across all those same stocks. What we see is that diversification does indeed leave us with a more balanced risk/return profile.
How much does implied volatility contract when there are up days?
Study * SPY * 2005 to present * Recorded the magnitude and frequency of volatility contractions when the market moved up
We find that the when the market moves up on any day, we see a vol contraction of 5% on average. When the market moves up by more than 1%, we see a vol contraction of 8.5% on average.
This segment of Options Jive looks at how many days calls and puts are in the money (ITM).
As option sellers, we want our options to expire out of the money. So how long do calls and puts typically spend in the money?
The study shows that on average, calls spend almost twice as many days in the money than puts. Calls are also more likely than puts to spend more than one day in the money.
Tom and Tony discuss why tastytrade prefers to trade the middle ground between average P/L and probability of profit.
Reasons include:
- less whipsaw and P/L volatility than higher delta strangles
- higher ROC than lower delta strangles
- higher opportunity in high IV markets than lower delta
Iron condors are one of tastytrade's commonly used defined risk strategies. But how do they perform when we look at specific market environments?
Study * Compared Iron Condors with short 30 delta options and long wings $5, $10, and $20 wide * All trades managed at 50% of max profit * 45 days to expiration * S&P 500 (SPY) * 2005 to present
Results The Research Department uncovered that in high and low IV Rank environments, the wider Iron Condor outperforms. However, in times of extreme selloff like 2008, the narrower Iron Condor outperforms because the wide IC was exposed to larger losses, as its long strikes were further away.
Gamma measures the sensitivity of option delta to changes in the underlying price, and theta describes the time decay of the extrinsic value of the option.
These two Greeks typically have an inverse sign relationship, meaning that a contract with a positive gamma will often have negative theta and vice versa.
This relationship, often described as the gamma-theta tradeoff, presents both benefits and risks to the buyers and sellers of options contracts.
Tune in as Tom and Tony walk through this concept.
Contrary to popular belief, volatility is not dependent on the directional price movements of underlyings. Certain underlyings tend to have a different relationship between price moves of the underlying
Volatility is dependent on magnitude of price movements and not the direction of price movements.
Tune in as Tom and Tony discuss this concept in depth!
Here we discuss correlation and cointegration, the differences between them, how they're measured, and what they're each used for. We also look at examples of ETF pairs that demonstrate both correlation and cointegration!
Although they are often related, correlated assets tend to move in tandem while cointegrated assets tend to have a mean-reverting spread. This makes correlation ideal when focusing on portfolio diversification, and cointegration ideal for strategies that rely on mean-reversion.
IV rank was developed in 2000 and has been improved since then to become a critical tool in determining trade decisions.
The fundamental reason for it working comes down to the philosophy of mean reversion in implied volatility.
As IV rank increases, there is a greater chance of IV mean-reverting and bringing profits to option sellers. When trades are placed in high IVR environments, we earn more than double the profits on average than when trades are placed in low IVR environments.