Expmonthly Vol3no2 Apr

7/27/2019 Expmonthly Vol3no2 Apr

1/24

April 2012 | Vo. 3 No.

MONTHLYT H E O P T I O N T R A D E R S J O U R N A L

Comparative

Implied and Realized

Inde Volatility

An Interview wit

Phil Flynn

RISK OR UNCERTAINTY:Explaining te Variance PremiumTradingExPIRATION

A QUESTIONofCAPITALEFFICIENCY


2/24

www.expiringmonthly.com April 2012 2

ONTHLYT H E O P T I O N T R A D E R S J O U R N A L

editorial

B lubyJaed Woodad

Mak Sebastan

Andew Govnazz

design/layout

lauen Woodow

contact information

Edtoa comments: [email protected]

Advetsng and Saes

Exng Monthy pesdentMak Sebastan: [email protected]

phone: 773.661.6620

The nfomaton esented n ths ubcaton does not consde you

esona nvestment objectves o nanca stuaton; theefoe, ths

ubcaton does not make esonazed ecommendatons. Ths nfo-

maton shoud not be constued as an oe to se o a soctaton to

buy any secuty. The nvestment stateges o the secutes may not

be sutabe fo you. We beeve the nfomaton ovded s eabe;

howeve, Exng Monthy and ts aated esonne do not gua-

antee ts accuacy, tmeness, o cometeness. Any and a ononsexessed n ths ubcaton ae subject to change wthout notce. in

esect to the comanes o secutes coveed n these mateas, the

esectve eson, anayst, o wte cetes to Exng Monthy that

the vews exessed accuatey eect hs o he own esona vews

about the subject secutes and ssung enttes and that no at of the

esons comensaton was, s, o w be eated to the secc ecom-

mendatons (f made) o vews contaned n ths ubcaton. Exng

Monthy and ts aates, the emoyees, dectos, consutants, and/

o the esectve famy membes may decty o ndecty hod os-

tons n the secutes efeenced n these mateas.

Otons tansactons nvove comex tax consdeatons that shoud

be caefuy evewed o to enteng nto any tansacton. The sk of

oss n tadng secutes, otons, futues, and foex can be substanta.

Customes must consde a eevant sk factos, ncudng the own

esona nanca stuaton, befoe tadng. Otons nvove sk andae not sutabe fo a nvestos. See the otons dscosue docu-

ment Chaactestcs and rsks of Standadzed Otons. A coy can

be downoaded at htt://www.otonsceang.com/about/ubcatons/

chaacte-sks.js.

Exng Monthy does not assume any abty fo any acton taken

based on nfomaton o advetsements esented n ths ubcaton.

No at of ths matea s to be eoduced o dstbuted to othes by

any means wthout o wtten emsson of Exng Monthy o ts af-

ates. photocoyng, ncudng tansmsson by facsme o ema scan,

s ohbted and subject to abty. Coyght 2012, Exng Monthy.

contents

4 e n

Bill Luby

5 a x

The Expiring Monthly Editors

6 t e

Andrew Giovinazzi

7 cv i rz

i V

Bill Luby

10 e m iv p f

Mark Sebastian

13 r u: e

Variance Premium

Jared Woodard

15 expiring monthly feature

A Question of Capital Eciency

Mark Sebastian

19 floorstories: h d w g h?

Andrew Giovinazzi

21 followthattrade: l-s s

t mj m i

Bill Luby

23 backpage: h m

Eric Kovalak, Guest Contributor
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3/24


About te

Expiring Montly Team

Bill Luby

B s a vate nvesto whose eseach

and tadng nteests focus on voatty,

maket sentment, technca anayss,

and ETFs. Hs wok has been has been

quoted n the Wa Steet Jouna,

Fnanca Tmes, Baons and othe

ubcatons. A contbuto to Baons

and Mnyanve, B aso authos the ViX

and Moe bog and an nvestment

newsette fom just noth of San

Fancsco. He has been tadng otons snce 1998.

po to becomng a fu-tme nvesto, B was a busness stat-

egy consutant fo two decades and advsed cents acoss a

boad ange of ndustes on ssues such as stategy fomua-

ton, stategy mementaton, and metcs. When not tadng o

boggng, he can often be found unnng, hkng, and kayakng

n Nothen Cafona.

B has a BA fom Stanfod Unvesty and an MBA fom

Canege-Meon Unvesty.

Jared Woodard Jaed s the nca of CondoOtons. Wth ove a decade of

exeence tadng otons, equtes,

and futues, he ubshes the Condo

Otons newsette (on condos) and

assocated bog.

Jaed has been quoted n vaous

meda outets ncudng The Wa

Steet Jouna, Boombeg, Fnanca

Tmes Ahave, and The Chcago Sun-Tmes. He s aso a con-

tbuto to TheSteets Otons pots sevce.

in 2008, he was oed as a to otons mento n Stocks,

Futues, and Otons Magazne. He s aso an assocate membe

of the Natona Futues Assocaton and egsteed nca of

Cnamen Fnanca Gou llC, a commodty tadng advso.

Jaed has mastes degees fom Fodham Unvesty and the

Unvesty of Ednbugh.

Mark Sebastian

Mak s a ofessona oton tade

and oton mento. He gaduated

fom Vanova Unvesty n 2001 wth

a degee n nance. He was hed nto

an oton tade tanng ogam by

Gou 1 Tadng. He sent two yeas

n New Yok tadng otons on the

Amecan Stock Exchange befoe

movng back to Chcago to tade SpX

and DJX otons Fo the next ve

yeas, he taded a vaety of oton oducts successfuy, both

on and o the CBOE oo.

in Decembe 2008 he stated wokng as a mento at Shedan

Oton Mentong. Cuenty, Mak wtes a day bog on a

thngs oton tadng at Oton911.com and woks at tme

as sk manage fo a hedge fund. in Mach 2010 he became

Decto of Educaton fo a new educaton m Otonpt.com.

AndrewGiovinazzi Andew Govnazz stated hs caee n

the nanca makets afte gaduatng

fom the Unvesty of Cafona, Santa

Cuz wth a B.A. n Economcs n 1989.

He joned Gou One, ltd. and qucky

became a membe of the pacc Stock

Exchange (and ate the CBOE), whee

he taded both equty and ndex

otons ove a 15 yea san. Dung

that eod he neve had a down yea.

At the same tme, Andew stated and an the Desgnated

pmay Maket Make ost fo GouOne on the oo of the

CBOE. it became one of the hghest-gossng osts fo the

comany n 1992 and 1993. Whe actvey tadng, Andew was

nstumenta n ceatng and managng an oton tade tan-

ng ogam fo Gou One.

He eft Gou One, ltd. to co-found Heny Cata Management

n 2001. Andew then joned Aqumn llC (20082011) to he

bng 3D quotng and anayss to nanca data. He s Chef

Otons Stategst at Oton pt.


4/24


Editors

NotesBill Luby

Ove the couse of the ast few ssues, sevea atces have

touched uon the subject of the vaance (voatty) sk e-

mum, aso known as Vrp. Ths month we have made Vrp

the centa theme of the ssue, tackng the subject fom sev-

ea deent anges.

in Risk or Uncertainty: Explaining the Variance Risk

Premium, Jaed Woodad begns the st of a two-at exam-

naton of Ambguty Aveson and Vaance pemum, a

ecent ae by Janjun Mao, Bn We, and Hao Zhou, that

oes an ambguty-based exanaton fo the vaance e-

mum uzze.

in a eated ven, ths month i addess the subject of Vrp

n two deent ways. in Comparative Implied and Realized

Index Volatility, i ook at Vrp acoss a vaety of majo ma-

ket equty ndces and i foow one tangent n a eated

Foow That Tade ece, Long-Short Straddles on Two Major

Market Indices.

Mak Sebastan authos ths months featue atce n

whch he deves nto some of the benets of ndex otons

as a moe ecent use of cata than tadng the coe-

sondng ETFs o ETNs decty.

ph Fynn s the subject of ths months featue ntevew.

Mak does the honos agan and the wde-angng dscus-

son sans the evouton of the commodtes makets and

the changes bought about by commodtes ETps to futues

stateges, tadng fequences, the nanca meda and

othe subjects.

Andew Govnazz descbes how weeky otons have

changed the natue of exaton tadng and have gven the

eta nvesto moe vabe tadng stateges. Andew aso

eects on the evouton of otons tadng ove the yeas n

tems of exchanges, technoogy and othe asects.

Once agan, the EM team s back to answe eade ques-

tons n the Ask the Xets segment, whe Ec Kovaak

makes hs Exng Monthy debut on the Back page, wth

some thoughtfu commentay on Mchgan that s thck

on otons metahos and some eassung news fo et

ownes.

As aways, eades ae encouaged to send questons,

comments o guest atce contbuton deas to edto@

exngmonthy.com.

Have a good exaton cyce,

B luby

Contributing Editor
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5/24


Q: Im relatively new to

the world of options. Ive

been reading a lot of the

risk management articles

in EM, and also about how

options can let you use

capital more eciently, e.g.

by using calls to replace

stock positions. Given how

eective options can be, is

there a reason an informed

investor wouldnt just trade

options exclusively?

M. Lefort

A: inteestng queston.

Thee ae some easons

you mght want to take a

oston n an undeyng

asset, nstead of ganng

exosue wth otons.

if you nvestments ae

ncome-oented, you

shoud just buy the unde-

yng asset. if you tme

hozon s vey ong, o

youe a buy-and-hod sot

of nvesto, the cost of o-

ng otons eodcay w

educe the othe benets

of ownng them nstead of

shaes. if you eason fo

takng a oston n a stock

s excusvey ce-based,

that s to say f you have no

othe vews about tme o

voatty, tadng otons

a the tme s a bad dea,

snce the oduct s moe

comex than you need.

An aveage stock nves-

to tadng otons aone

woud be ke someone who

bought a Tesa roadste

just to go to the gocey

stoe.

Thats not to say that

Tesas, and otons, aent

fantastc oducts fo

eoe who can make use

of them. i woud ague that

a smat nvesto should

wok to ncooate exct

vews about tme and

voatty nto he os-

tons, snce those vews ae

obaby oeatve anyway

on an mct eve. in the

accounts i manage fo c-

ents and mysef, the buk ofou exosue s n otons

contacts and seads. But

agan, the aoateness

of a nanca oduct s a

vey esona matte.

Jaed

Q: Whats the dierence

between volume and openinterest?

David

A:Ths s a common

mstake that newe tad-

es sometmes dont get.

Voume s etty sme:

t s the tota numbe of

contacts that changed

hands on a gven day. Oen

nteest s not neay as

sme. When thee s a ot

of tadng some s done

to cose an exstng tade.

Othe tades ae done as

new oenng ostons.

Thnk buyng a stock and

then seng t to cose the

ong vs. seng to se shot

a stock. On the sde,

buyng to cose a shot sae

vs. buyng to go ong. Oen

nteest eesents how

many tades ae ong and

shot at any gven tme. if

a tade buys a ca fom

anothe tade (techncay

actuay the OCC but that

s a an entey deent

dscusson) the tade tsef

ceates an oen nte-

est of 1. if the same two

tades then tade back, t

woud decease oen nte-

est of -1. What f a tade

that s ong a contact

ses t back to the maket

ace and a tade that dd

not have an oen oston

buys the contact? it woud

have a net eect of 0 on

oen nteest. By studyng

the deences between

voume and oen nteest,

tades can get nsght nto

whethe a age bock tade

s a tade oenng a tadeo cosng a tade. it can be

a geat too fo o tades.

Mak

Q: Can a trader hedge

Sep VXX options with Apr

VXX options? Are these

well-enough correlated?

Mark

A: Setembe and A

VXX otons ae decton-

ay coeated fo the most

at, but the undeyng

futues they ae based o

Ask te

pertsThe Expiring Monthly Editors

By studyngthe deences

between

voumeand oennteest,tades can get

nsght ntowhethe a agebock tade s a

tade oenng a

tade o cosng

a tade. (continued on page 24)


6/24


Trading

ExpirationAndrew Giovinazzi

expirationtradingused to beknd of a back at. reason beng t ony

haened once a month and ostons

had to tme to matue. The gadua

change fom vega-oented ostons

to gamma-oented ostons ae knd

of ke sngtme fo the East Coastes.

You neve know what woud o out of

the gound (o o the sheets). The sow

tck tock of theta usuay scaes most

tades. Wth the advent and sng

ouaty (and qudty) of the Weekys

(anothe geat CBOE oton nventon)

now s a good tme to dg nto exa-

ton snce t s not just fo os anymoe.

Moving into Epiration

The key at of exaton tadng s the

changng eatonsh of gamma (how

senstve the oton s to a change n

the undeyng) and vega (how sens-

tve the oton s to a change n voat-

ty). Snce ce and voatty ae the

two most vaabe nuts to the oton

mode the gadua move n motance

to gamma s a bg dea. Fom a oston

management esectve the tades

has to ask, Do i want ths gamma?

A oston ut on fom a vega ont

of vew w no onge eay efom

as a vega sk-tye tade. Fo onge

tem ostons sdng nto exaton,

thnk ong and had about those vet-

ca seads and ion Condos. is the

eason they wee ut on st vad as a

gamma domnant tade?

Open Interest (OI) vs. Volume

The advent of the Weekys ceates

a new contact cyce evey week fo

many of the bggest

tadng names. The

queston we get at

Oton pt a the tme

s about Oen inteest.

Do i want to tade a

contact that has such

ow oen nteest?

The answe, of couse, s a Weeky has

no oen nteest because t was newy

sted and nothng has taded yet. But,

voila, one hou of actve tadng can and

w geneate huge oen nteest. Oen

nteest at exaton meey means

thee s a ossbe gavtatona foce to

the bg Oi stke snce thee s someone

on one sde who has a age ostve

gamma oston. if the oston s bg

enough to n the undeyng, the bg

Oi stke s vey we whee t coud end

u. Utmatey f tades ae ookng fo

qudty, bette to ook at the sze of the

bd/ask. if the oton sees s qud on

enty t most key w be qud on ext.

Eploding Gamma and Rapid

Decay

Fo the sake of bevty i w teat a

otons hee as the exaton week

eod (Thusday befoe to the day of

exaton, o about eght days). The

ony ea deences between the

Weekys and Odnaes ae the egacy

Oi n the Odnaes comng nto exa-

ton and the Weekys wth the eatvey

owe Oi. Gamma w mach u evey

day unt exaton. What the ostons

get s ady evaoatng theta as ex-

aton day daws nea. Nce ostons

game the shot font month contact fo

a quck nancng of the second month

contact. Tme seads of vaous tyes

wok we hee on the Thusday o Fday

befoe exaton (78 days befoe)

fo ady decayng otons. St the

stke and tades can ck u some

etty chea otons. The advent of the

Weekys makes ths tade stuctue os-

sbe week afte week.

Gaming te Epiration Position

As the day of exaton aoaches,

otons become that geat bnoma

tade, the a o nothng. A cose on

exaton .01 above the stke gves

a vana ca 100 detas and .01 beow

the stke 0 detas. if a tade os-

tons a shot deta aganst that what do

they get? That s an nstant exosve

gamma backsead fo the ages. The

name beaks and the tade becomes

a nce wnne o the name stays at o

above the stke fo a scatch o sma

oss. Fo tades wth egacy ostons

and Weekys that have become us

(OTM otons wth tte hoe of fe) the

one-day gamma event s the deam.

pace stock odes above the maket

(nea the ong stke ce) o tade

haf of the detas when the undeyng

moves to the stke. A quck tunabout

w yed fantastc esuts. EM

Now s a good tme todg nto exaton snce t s

not just fo os anymoe.


7/24


Comparative Implied and Realized

Index VolatilityBill Luby

whenitcomestoboad mea-sues of med and eazed voatty,

most nvestos tend to focus a of the

attenton on the S&p 500 index (SpX)

and ts med voatty counteat,

the CBOE Voatty index (ViX). As the

SpX and the ViX ae the undsuted

benchmaks fo boad-based equty

ndces and med voatty, a stct

adheence to these two ndces s ce-

tany undestandabe.

is an SpX and ViX-centc vew of

voatty justed? is t desabe? What

addtona nfomaton can nvestos

gean fom montong med and

eazed voatty n some of the othe

majo maket ndces?

Ths atce examnes the de-

ences n med and eazed voatty

as measued by the SpX/ViX and fou

othe boad-based equty ndces and

the voatty ndex as:

S&p 100 index (OEX) and CBOE

S&p 100 Voatty index (VXO)

NASDAQ-100 index (NDX) and

CBOE NASDAQ-100 Voatty index

(VXN)

Dow Jones industa Aveage (DJiA)

and CBOE DJiA Voatty index

(VXD)

russe 2000 index and CBOE

russe 2000 Voatty index (rVX)

Correlation and Beta o

Volatility Indices

Of a the voatty ndces noted

above, the newest to the aty s the

rVX, whch was aunched n May 2006.

The CBOE has econstucted ViX data

gong back to Januay 2004, howeve,

whch makes t ossbe to anayze

the vaous movements of the voat-

ty ndces fo moe than eght yeas

of hstoca data. Fgue 1 summazes

some of the key facts about these vo-

atty ndces.

As Fgue 2 shows, thee s a hgh

degee of coeaton acoss the ve

man voatty ndces. Usng data

gong back to the begnnng of 2004,

the coeaton between the ViX and

the fou othe boad-based voatty

ndces anges fom a hgh

of .997 fo VXD to a ow of

.974 fo VXN. As one mght

exect, the coeaton

between ViX and ts e-

decesso, VXO, s aso vey

hgh at .994. The coea-

ton between ViX and rVX

s towad the mdde at

.985. Coeatons between

the othe fou voat-

ty ndces ae geneay

sghty owe than those

wth the ViX. One exce-

ton s VXD and VXO, whch

s vey stong at .994.

The weakest coeaton

acoss the ente coeaton matx s

between VXN and rVX and even then

a .965 coeaton s nothng to sco at

Cacuatng the beta of these voa-

tty ndces fom 2004, the esuts

aea to be nuenced by the maket

catazaton of the secutes n the

undeyng ndex. Fgue 3 shows that

eazed o hstoca voatty (HV) n

the russe 2000 ndex has been 39%

hghe than the SpX snce 2004, whe

HV n the NASDAQ-100 ndex has been

16% hghe dung the same eod.

On the othe sde of the edge, HV fo

the OEX has been 4% ess than the

SpX, on aveage, whe HV fo the DJiA

has been 8% owe.

Figure 2 Volatility Index Correlation Matrix,

20042012

Figure 1 Comparative Volatility Indices

CBOE

,ViXandMore

Figure 3 Mean Equity Index Historical

Volatility, 20042012

* Note that the asterisk [Fig. 1] with respect

to the launch dates for VIX and VXO is areminder that the formula used for calcu-

lating the VIX was revised in Sept. 2003.

As a result, the VIX data set includes the

published VIX data from 2003 to the pres-

ent as well as reconstructed data going

back to 1990. The VXO data were origi-

nally published under the VIX label from

19932003, was reconstructed going back

to 1988, and has been published as VXO

since 2003.


8/24


Implied Volatility and te

Volatility Risk Premium

Whe some mght consde the above

to ncude some modeatey nteest-

ng factods, the data becomes moe

comeng when we stat comang

and contastng hstoca voatty

wth med voatty. At st gance, a

tabe of the voatty ndex data fom

20042012 (see Fgue 4) ooks to

cosey esembe the hstoca voat-

ty data shown n Fgue 3, athough

t s obvous that the med voat-

ty data ae geneay 1520% hghe

than the coesondng hstoca

voatty data.

Gven the vaety of voat-

ty egmes we have wtnessed ove

the couse of the ast eght yeas, i

thought t mght be nstuctve to ca-

cuate the voatty sk emum [cal-

culated as the volatility index from 21

trading sessions ago divided by the

current 21-day historical volatility] o

Vrp and see how the Vrp has uctu-

ated on an annua bass fo each of the

ve voatty ndces. The esuts ae

summazed n Fgue 5.

it s not susng, but st nteest-

ng to note that 2008 s the ony yea

n whch the mean voa-

tty ndex eves dd not

show a emum ove the

mean hstoca voatty

vaueand ths hed tue

fo a ve voatty nd-

ces. Ths s n sha con-

tast to the st 16 weeks

of 2012, whee med

voatty has exceeded

eazed voatty by at east 53% n

each of the ve voatty ndces. Note

that the o hghs n Vrp wee fom

2004 and 2009/2010, when stocks

wee eboundng fom a sha down-

tun and thee was wdesead sket-

csm about the sustanabty of the

ay.

The geen shadng n Fgue 5

dentes the voatty ndex wth the

hghest Vrp, whe the ed shadng

shows the ndex wth the owest Vrp.

inteestngy, the VXO/OEX combna-

ton has consstenty demonstated

vey hgh Vrp and has had the hgh-

est Vrp n seven of the eght yeas

n whch thee s a fu set of data. At

the othe end of the sectum, the

rVX/rUT combnaton has conss-

tenty demonstated the owest Vrp

among the gou snce the 2008

nanca css.

Conclusion

Dawng uon data fom 2004 to the

esent, i have bey examned the

coeaton, beta and voatty sk

emum acoss the ve majo maket

equty voatty ndces (ViX, VXN, VXO,

rVX, VXD) and the coesondng

undeyng equty ndces (SpX, NDX,

OEX, rUT, DJiA).

Dung the couse of the eght us

yeas coveed n ths anayss, the co-

eaton data fo the voatty ndces

was unfomy hgh and othewse

unemakabe. The beta of the voat-

ty ndces showed consdeaby moe

dvesty and foowed a atten n

whch the mean vaues of the voat-

ty ndex wee nvesey eated to the

maket catazaton of the stocks

comsng the undeyng ndex, wth

the rVX and russe 2000 ndex beng

the most voate, whe the VXD and

Dow Jones industa Aveage wee the

east voate.

The most nteestng ndngs come

fom a comason of the voatty

ndces to the eazed voatty n the

equty ndces. Hee thee was a stong

voatty sk emum (Vrp) acoss

the boad, most onounced n the

VXO and S&p 100 ndex and east o-

nounced n the rVX and russe 2000

ndex. it shoud be noted that some

tades efe to use an absoute df-

feence between the voatty ndex

and eazed voatty n cacuatng

Vrp. Usng ths tye of anayss causes

Comparative Implied and Realized Inde Volatility (continued)

Figure 4 Mean Volatility Index Levels,

20042012

Figure 5 Annual Volatility Risk Premium, 20042012


9/24


ony sght changes n the esuts: VXO/

OEX and ViX/SpX woud st be st

and second n absoute tems, whe

rVX/rUT woud move u fom fth

to fouth, wth VXD/DJiA fang to

the bottom.

in tems of mcatons fo tad-

es, undestandng the deences n

maket catazaton and uctuatng

secto weghtngs n the undeyng

ndces s the st ste towad usng

the ndces as ndcatos o to set u

otons tades. Fo nstance, whe the

OEX s a subset of the SpX, t has a

geate weghtng n enegy, wheeas

the SpX aces moe emhass on

nancas and heath cae. The NDX

s obaby the most ehemea of

a, wth ve stocks (Ae, Mcosoft,

Googe, inte and Oace) cuenty

accountng fo aoxmatey 42% of

the ndex.

i w deve nto some of the ssues

ased by ths atce n futue ssues

and have aeady cked u one

eated thead n ths months Foow

That Tade: Long-Short Straddles on

Two Major Market Indices. EM

Further Reading

Foow That Tade: long-Shot Staddes

on Two Majo Maket indces,Expiring

Monthly, A 2012.

rsk o Uncetanty: Exanng the Vaance

pemum,Expiring Monthly, A 2012.

Why ViX Otons ae rchy pced,Expiring

Monthly, Mach 2012.

Foow-Though n Monthy Voatty rsk

pema,Expiring Monthly, Febuay 2012.

Huge pemum fo Equty Maket Vaance

Swas?Expiring Monthly, Novembe

2011.

Comparative Implied and Realized Inde Volatility (continued)
http://www.expiringmonthly.com/issue-mar-2012.htmlhttp://www.expiringmonthly.com/archives/follow-through-in-monthly-volatility-risk-premia.htmlhttp://www.expiringmonthly.com/archives/follow-through-in-monthly-volatility-risk-premia.htmlhttp://www.expiringmonthly.com/archives/huge-premium-for-equity-market-variance-swaps.htmlhttp://www.expiringmonthly.com/archives/huge-premium-for-equity-market-variance-swaps.htmlhttp://www.condoroptions.com/http://www.expiringmonthly.com/archives/huge-premium-for-equity-market-variance-swaps.htmlhttp://www.expiringmonthly.com/archives/huge-premium-for-equity-market-variance-swaps.htmlhttp://www.expiringmonthly.com/archives/follow-through-in-monthly-volatility-risk-premia.htmlhttp://www.expiringmonthly.com/archives/follow-through-in-monthly-volatility-risk-premia.htmlhttp://www.expiringmonthly.com/issue-mar-2012.html


10/24


Expiring Montly Interview wit

Pil FlynnMark Sebastian

Expiring Monthly: Tell us a little bit

about yourself.

Phil Flynn: i am kd fom the South

Sde of Chcago, somethng i eay

beneted fom. When i was ookng

fo a summe job my dad sad Hey,

i know ths boke on the oo (of the

CBOT) why dont you go down thee

and get a summe job on the oo.

i neve ooked back, and i thnk that

was 19781979. i eay got a geat

educaton about fe, makets, econ-

omy, and otcs n the best schoo

aound, whch s eay the tadng ts

n Chcago.

EM: Eventually you went out on your

own and became a broker? Trader?

Market maker?

PF: i have bascay done about a of

t on the oo. i have many woked

on the oo. Eay n the day, when

dscount commsson came nto ay,

i woked wth Bay lnd (of lnd-

Wadock). i stated wth lnd-Wadock

when they stated the dscount dv-

son. i was wth them fo many, many

yeas, unt i became an o-the-oo

tade. i used to wok wth Bay lnd

decty. i dd hs magns, hs chats,

. . . i eaned a ot about tadng fom

Bay. Bay was a genus tade. He

wote a book caed Method Tadng,

whch ae the basc ues that i st use

to ths day. You dont get that tye of

educaton anymoe. i eaned to tade

because a tadng m sad, You ook

ke a bght kd, so i am gong to et

you cek fo us whe we teach you

to tade.

EM: Whats the best way for traders

to learn how to trade and learn these

nancial markets?

PF: in one way, you ae neve gong

to ean they way i dd. in anothe way,

thee ae a ot moe ootuntes,

because tades have access to moe

nfomaton fom the ntenet and fom

tadng atfoms, but t w neve be

the same. They w neve exeence

the way we used to exeence beng

n the tadng ts afte a bush eot

and stenng to the oa. You ddnt

even have to ook at the boads to

know whethe t was a bush o bea-

sh eot. it was ke a ba game, you

ddnt have to ook to know f the guy

stuck out, o ht a home un, o what.

That was how t was n the tadng ts.

it was that mass humanty tadng, t

was sttng, t was sweang, t was

knockng eoe ove. But at the end

of the day, t was the best way of ce

dscovey that was known to man. To

ths day, i mss t. Today what you have

to do, you have to ead eveythng, you

know i scan a the stes. You shoud

watch Fox Busness Netwok, obvousy

You shoud check n wth WSJ, iBD, . . .

you just cant get enough nfomaton.

EM: Lets talk about the commodi-

ties markets now that they have gone

electronic. What direction do you think

the commodities markets are going

like equities, all electronic? Same

underlying? Same multiplier? I hear all

the time from the retail market what

makes trading commodities so hard is

that every contract is dierent.

i n t e r V i e w

Phil Flynn is a senior market

analyst atPFGBEST Research

and a daily contributor to the Fox

Business Network. Read his daily

energy reportand e-mail him at

[email protected].
http://www.pfgbest.com/services/research/?LSD=SFO%20Website%20-%202011&LSC=3rd%20party%20Web%20Site&BID=&CID=&BEM=http://www.pfgbest.com/services/research/blogs/energy-report.aspmailto:pflynn%40pfgbest.com?subject=mailto:pflynn%40pfgbest.com?subject=http://www.pfgbest.com/services/research/blogs/energy-report.asphttp://www.pfgbest.com/services/research/?LSD=SFO%20Website%20-%202011&LSC=3rd%20party%20Web%20Site&BID=&CID=&BEM=


11/24


PF: i thnk thee s some tuth n that,

and sometmes, thee ae contacts i

nd confusng to ths day. You wonde

why they make these thngs so com-

cated. i w gve you a efect exam-

e. Wth the Fedea reseve, the fed

fund futuescontact, a ot of eoe

taded t, but the genea ubc ddnt

undestand t. Why? Because you had

to do a these comcated math o-

gams. Fgue out when the fed meet-

ng s, dvde by 7, and do a these

thngs to gue out what the maket s

teng you. Whee f you woud have

exessed t n such a way whee, Hey,

we have a 70%80% chance, the gen-

ea ubc woud have bought n. i do

sometmes thnk t s the way the con-

tact s stuctued that causes eoe

not to tade these thngs.

But what s haenng s the ETFs

you dont have to undestand. And

that has been a bg boom to the ma-

ket, and i thnk a bg ostve boom.

You know the ant-secuatve cowd

says ts the wost thng to eve ha-

en to commodtes. They ae wong;

i thnk t s the best thng to haen to

commodtes.

EM: How do you handle USO and UNG,

that have some of the contango prob-

lems. Whats the key to trading those

types of ETFS?

PF: Fst of a, you ae ckng the

maket that has been n a bea maket,

and you aso have to consde the fact

that the ETF s n ts nfant stage. The

way i ook at that s one of the bggest

obems we have had n the futues

makets n natua gas and enegy s

ce dscovey fo 20 yeas o 5 yeas

down the oad.

We used to have that befoe they

changed the taxes n the 80s, they had

the tax advantage, so you coud have

a maket made way out nto the futue.

The obem we have had n the

natua gas UNG: you know that t s

vey dcut to ceate nteest n that

at of the contact, because t just snt

thee. You know we stat these ETFs,

and we have to concentate on the

font end of the contact. it has ceated

a few settement obems at the end.

We have a seconday maket wth

ETFs whee eveybody who may want

to be shot o ong natua gas, can

dve u the ce of the stock hghe

than the commodty. To me that coud

aso be a usefu ndcato fo tadng,

as vad as ehas a ViX ndex, to

show the tade sentment.

if eoe ae wng to buy an

ETF above the maket vaue, t eay

shows the undeyng demand fo that

commodty s eay ovedone, o t s

somethng you have. But you know

deste the fact that t may have

caused some shot tem obems at

an exaton o two, n the bg ctue.

What t s gong to do s ceate

moe oducts fom that contact. We

ae gong to nd oducts that focus

on the font end, the back end, and

soon you w have an aveage of a

the deent contacts. Why ths s

motant fo the oduces s because

as you get that qudty n the maket,

and you can ook at the maketace

and say, Hey, i can make an nvest-

ment on a mutbon doa o dea f

i know i can ock n 30 doas a bae

nto the yea 2100 o to whateve t s,

and that can be a ea us. it s gong

to take some tme to deveo, so i

dont thnk you can get too ove-uset

ove the shote tem stuatons.

EM: Lets talk about what you do

throughout the day. You are a contribu-

tor at FOX. How do you like working for

a network, and whats your experience

been like?

PF: i ove t. i eay do. Numbe one,

i am a bg ham. Thats a ot of fun.

Numbe 2, the eoe at FOX ae he-

nomena. i am vey excted beng at

ths new netwok. Thee s some nced-

be taent ove thee. i just want moe

eoe to nd us. i thnk, once they

tune nto the netwok, they w be

amazed. its not busness as usua. its

not what you see on CNBC. i thnk t s

busness wth a swagge. it s a de-

ent dea. You know, beng down on the

oo, i woud ke to thnk FOX es-

ents the makets n a unque way that

i thnk ovdes vaue fo the aveage

nvesto. A ot of tmes you woud tun

on some of the othe busness statons,

and some of the eoe who watch

woud be snnng the heads ke what

the heck ae they takng about? i thnk

wth FOX they bng t down to a eve

that amost anybody can undestand.

EM: At PFG Best, who are your clients?

PF: i have a vey dvesed base of

cents. i have a ot of what we ca

Epiring Montly Interview wit Pil Flynn (continued)


12/24


eta busness, the aveage nvestos,

but we aso have some CTAs, some

commodtes funds, and hedge fund

accounts. Geneay seakng, what i

do s eseach fo the m, and bas-

cay fo most cents, we ceate tad-

ng ogams fo them based on what

they te us. You know, whateve the

cent s ookng fo.

Some say to me, ph, i want to

nvest $25,000, and i want to be moe

aggessve and i want to tun t nto

whateve, and we woud ceate a

moe aggessve tadng ogam. if

someone came to me and sad, ph,

ths s $25,000. i want to be a tte

moe consevatve. i know futues

ae sky, and you can ose money on

evey tade. We can ceate a ogam.

i thnk ou vaue fo the aveage

nvesto s i get them thnkng about

sk vs. ot otenta. Most of the

customes that i have seen that come

nto ths maket, they thnk ot,

and they dont thnk sk. They dont

have a good sod an n the maket

of what they want to do. One of the

wost thngs that has haened to a

ot of eta tades s dee dscount

tadng. it encouages a ot of these

tades to tade too much. peoe

come n and say ts ony $2. We,

nstead of dong one, i can do ve o

sx, and they ae back and foth a

day. One of the wost thngs someone

can do s st n font of a one-mnute

ba chat a day and tade back and

foth 50 tmes a day. They end u at

$75 afte commssons on the day, and

to me thats a osng stategy ove the

ong un, because they ae takng an

ncedbe amount of sk.

What i te eoe s, my hosohy

fo most eta tades s tade ess and

ty to make moe. You do that by bas-

cay ceatng a ogam whee you ae

thnkng about you ot vs. you sk

otenta. Qut tyng to tade the next

two mnutes. look at evey day as a

new day as an ootunty to buy the

ow and se the hgh. Thnk about the

ong tem, and you w do much bette.

EM: So do you work with active trad-

ers, or are you developing more kind

of the I have $1,000,000, and I want

$100,000 invested in commodities,

and I want you to handle it? Do you

help the day trader or the long term

guy or both?

PF: My hosohy s ths: f i am stat-

ng a new ogam, t s thee stes.

Thnk day tade st, swng tade sec-

ond, and oston tade thd. Thats

my hosohy. Wheneve i am uttng

on a ogam, when i am uttng on a

tade, f i dont thnk that that atcu-

a tade has a chance to make a ot

n that atcua tadng sesson that

i am uttng t on, then i dont want

to do that tade. Obvousy not evey

tade s gong to wn. i want to have a

an that says, hey, ths coud be the

ow of ths tadng sesson, ths coud

be the hgh. Then i woud un deent

sk scenaos. OK, what f we have a

suse? What woud be the next eve

of sk? What woud be an outsde day?

So ou un fo evey maket evey day

obaby has fou o ve scenaos

fo that day. Why s that motant?

Because then we canagan gettng

back to sk vs. ot otentacome

back to you and say you know i can

tade any maket. i can ceate a sys-

tem fo mute makets.

EM: If somebody is looking to work

with you, you help day traders and

active traders. Do you do passive

management?

PF: Vey seectve. i dont do a ot of

that. Ony fo seect eoe. i thnk

sometmes, when we ty to become

a CTA o tade a secc ogam,

we geonhoe ouseves. i thnk, to

be honest wth you, f i can hande a

much geate centee, i can advse

anes, the aveage Joe, enegy funds

that use ou eseach and use ou

advce.

EM: You have to go through PFG to

work with you?

PF: Yes.

EM: Anything else you want to bring

up that we didnt bring up?

PF: if you audence s thnkng about

gettng nto futues, thnk about you

sk vs. ot otenta. Futues ae

vey sky. You shoudnt be gettng

nto t uness you have money you can

aod to ose. The ones who get nto

t, be vey conscous of sk vs. ot

otenta. Dont ut on a tade to just

ut on a tade. No ng a con. Get

away fom the systems that have tad-

ng 35 tmes a day. You dont need to

tade 35 tmes a day. EM

Epiring Montly Interview wit Pil Flynn (continued)


13/24


Risk or Uncertainty: Explaining te

Variance PremiumJared Woodard

readersofthisjournalwbe fama by now wth the vaance

o voatty sk emumthe de-

ence between the voatty med by

otons ces and the voatty exhb-

ted by the undeyng asset. Whe the

exstence and sze of the emum ae

emcay undenabe, attemts to

exan why the emum exsts have

been somewhat ad hoc. Seccay,

o attemts n the teatue have

tycay assumed standad asset c-

ng modesncudng the exected

utty hyothess on whch those mod-

es eyand then added on factos

eesentng stochastc voatty of vo-

atty o exteme ta sk to exan the

exstence of the vaance emum.

Ad hoc modes ae undesabe

because they ae uneabe. if ou best

economc mode ees on an mau-

sbe assumtonthat agents fun-

damentay act atonayand then

weds on extena factos when needed

to exan emca henomena ke

the vaance emum, then t s hade

to have condence that the exana-

tons and edctons of the mode w

hod tue ove tme.

in Ambguty Aveson and

Vaance pemum, Janjun Mao, Bn

We, and Hao Zhou ague that the va-

ance emum can be bette exaned

n tems of ambguty athe than sk.

The abstact fo the ae s beow:

ltte s known about the vaance

emum uzzethe hstoca

vaance emum (the deence

between sk-neuta and objec-

tve exectatons of maket etun

vaance) s an ode of magntude

geate than can be atonazed n

a standad asset cng mode. in

ths ae we ovde an ambguty-

based exanaton fo the vaance

emum uzze. Seccay, we

show that ou mode can endog-

enousy geneate a szabe va-

ance emum to cosey match the

magntude n the data. Moe mo-

tanty, we nd that ambguty ca-

tues about 96 ecent of the mode

med vaance emum wheeas

sk can ony exan about 4 ecent

of t. Ou mode aso matches the

eves and voattes of the equty

emum and the sk fee ate.

Ayng the mode to hstoca con-

sumton data, we nd that vaance

emum mosty catues dees-

sons, dee ecessons, and nanca

ancs, wth a ost wa eak n 2009

To undestand the deence, t s

motant to know that sk and amb-

gutysometmes n the teatue:

uncetantyae used as technca

tems. A sky stuaton s one n ange

of ossbe outcomes s nte and s

known n advance to the agent. An

exame fama to otons tades

mght be ownng a vetca ca sead.

if the undeyng dos beow a cetan

eve, the emum ad fo the sead

w be ost; f the undeyng ses above

a cetan eve, the sead w be max-

may otabe and w not accue any

moe gans. in othe wods, the nte

ange of ossbe outcomes s easy

detemned, whch means we can aso

nd ways of eachng eabe estmates

of the obabty of those outcomes.

But now magne a stuaton n whch

you own a ca oton and you ony know

the cuent ce of the oton, but not

the stke, the ce of the undeyng,

the oton med voatty, o any othe

nfomaton. You ae asked to dete-

mne how obabe t s that the otons

ce w doube n vaue befoe exa-

ton. Thats an mossbe estmaton to

make: thee ae an unknown numbe of

ossbe outcomes, so thees no way to

assgn obabtes to them ndvduay.

Economsts and hosohes ca ths

knd of estemc stuaton uncetanty

o ambguty.
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14/24


The dstncton between sk and

uncetanty shoud not be confused

wth the ooston between exected

utty and behavoa aoaches to

economcs. The atte dstncton s

about descbng how agents actu-

ay act: fo exame, gven a tue set

of obabtes, do agents make bets

consstent wth those obabtes?

Exected/atona utty theoy asks us

to assume that they do, whe behav-

oa aoaches ncudng osect

theoy conm that agents often dev-

ate. The sk/uncetanty dstncton s

about whethe a gven stuaton even

admts obabty estmates n the

st ace.

To exan how ambguty aveson

make sense of the vaance emum,

the authos cam that the vaance

emum can be decomosed nto

thee comonents.

The st comonent s the de-

ence between the exectatons about

a boom state (a eod of sustaned

gowth) between an agent whose

beefs match an exected utty func-

ton (Bayesan anayss) and an agent

whose beefs ae uncetan. Ths st

comonent s ostve because unce-

tan, ambguty-avese agents ut

moe weght on ecessonay e-

ods and ess on gowth eods than

do atona utty-dven agents. The

authos ey on a evousy ntoduced

ambguty mode to estmate the ave-

son of maket atcants.

The second comonent s the df-

feence between the voatty of the

maket dung a boom and the ma-

ket voatty dung a ecesson. The

vaue of the second comonent s aso

ostve because voatty s counte-

cycca: maket voatty tends to be

hghe when gowth s ow (n a eces-

son) and vce vesa. Because unce-

tan agents undeweght good news

and oveweght bad news (e the st

comonent), they can be exected to

oveay fo hedges, feedng nto the

counte-cyccaty of maket voatty.

The thd comonent nvoves the ea-

tonsh between voatty and ces,

but s not motant fo ou uoses.

An economc mode s ony as vau-

abe as the tue edctons t makes,

so the authos comae the abty of

the ambguty mode aganst sevea

conventona aoaches. The esuts

ae stkng, and n the second at of

ths atce, i w exan those esuts

and dscuss what mcatons the

ambguty-aveson exanaton has

fo nvestos and tades who manage

stateges desgned aound the exs-

tence of the vaance emum. EM

Risk or Uncertainty: Eplaining te Variance Premium (continued)

Specializing in Trade Structure, Risk Management and Capital Efficiency

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Visit Our Website

The sk/uncetanty dstncton s about whethe

a gven stuaton even admts obabtyestmates n the st ace.
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15/24


M O N T H LY F E AT U R E

by Mark Sebastian


16/24


What s the most motant at to becomng a suc-cessfu tade? Thee ae those that say ts skmanagement, thee ae those who woud say t takes a good

stomach. Othe tades w say ts havng a geat system

o beng eay smat. Heck, thee ae those that thnk ts

comutes that make good tades, not tades who make

good tades (whe thee may be a hnt of tuth to that;

good comutes, ke anes, need good ots). if i wee to

sum thngs u n a shot sentence, i woud say ths: Good

tades nd the way to use the cata n the most ecent

manne ossbe. By that i mean, tades that nd the way

to use the money n the best tades become successfu.

Whe that may sound ke a huge no duh statement, i

thnk uon evew, many tades need to examne how much

tme they send anayzng how ecent they ae wth the

cata. i am cetan that thee ae tades who do tte to

nothng to ty and ensue that they ae ecent tades.

Whe tadng ecenty s meant moe fo a sees of books

than an atce fo a magazne thee s one subject that ts

neaty wthn these ages: seectng the ght oduct to

tade a stategy. By ths i mean, shoud tades be usng

ETFs o ndex otons, somethng that few tades consde.

We w dscuss the advantages of each tye of oduct, and

then oe a few stes to he tades make the necessay

stes to move towad the ght oduct.

ETFs

Exchange Taded Funds, o ETFs, and the cousns, ETNs,

whe cetany efomng the ogna ntenta cheae

atenatve to mutua funds and ndex fundshave sowy

exanded the sectum of makets they cove. in that tme,

we have aso seen the voume of ETFs exode. in many

ways, the majo dve of the US maket s the ETF makets.

incedby thee ae ove 20 ETFs and ETNs that tade ove

12 mon shaes a day on aveage (Tabe 1).

incedby, the SpY tades ove 145 mon shaes a day.

An ncedbe 19.8 bon doas a day n assets changng

hands evey day, a fu of the tota assets unde manage-

ment evey day. Based on the voume n the ETFs, one thng

shoud be cea: whe thee ae nvestos that buy and hod

these oducts, thee s a subset of tades that ae movng

mons of these shaes back and foth evey day. Be t HFT,

day tade, o swng tade, ETFs and ETNs ae extemey

oua to tade actvey.

lke the undeyng nstuments, the ETF otons ae aso

sue actve. The SpY tades an aveage of ove 2.2 mon

contacts a day1, on a notona vaue; the SpY actuay tades

moe shaes a day than the undeyng nstument. Othe

casses ke QQQ, iWM, EEM, and XlF aso tade massve vo-

umes on a day bass. Heen es the geatest advantage of

the ETFs fo the aveage oton tade: qudty. Makets n

SpY and othe actve ETps (exchange taded oducts) ae

tycay .01.02 wde n the font month otons, even n-

the-money otons ae often neve wde than a few ennes

A Question o Capital Efciency (continued)

Table 1 The 21 ETPs that trade over 12 million shares a day

on average

sb n av V aum

SPY SPDR S&P 500 145,945,875 $99,880.4 M

XLF Financial Select Sector SPDR 78,824,977 $6,865.4 M

EEM MSCI Emerging Markets Index Fund 51,456,422 $38,362.7 M

IWM Russell 2000 Index Fund 50,923,254 $14,402.8 M

QQQ QQQ 49,500,559 $33,290.9 M

VXX S&P 500 VIX Short-Term Futures ETN 39,129,117 $1,617.8 M

TZA Daily Small Cap Bear 3X Shares 23,134,785 $690.4 M

VWO Emerging Markets ETF 21,698,695 $53,704.8 M

EFA MSCI EAFE Index Fund 19,432,051 $36,038.4 M

SLV Silver Trust 19,074,975 $9,701.2 M

SDS UtraShort S&P500 17,629,369 $2,068.6 M

FXI FTSE China 25 Index Fund 17,311,320 $6,194.3 M

EWJ MSCI Japan Index Fund 16,127,713 $5,510.9 M

TNA Daily Small Cap Bull 3X Shares 14,717,560 $770.6 M

TVIX Daily 2x VIX Short-Term ETN 14,487,792 $449.9 M

EWZ MSCI Brazil Index Fund 14,473,947 $8,708.9 M

XLE Energy Select Sector SPDR 14,424,972 $7,462.1 M

FAZ Daily Financial Bear 3X Shares 14,198,068 $764.7 M

GDX Market Vectors TR Gold Miners 13,136,818 $6,187.0 M

XLI Industrial Select Sector SPDR 12,497,666 $3,221.2 M

GLD SPDR Gold Trust 12,212,763 $67,860.8 M


17/24


Obvousy, as tades move futhe away fom font month

otons, seads wden, but fo a ntents and uoses a

tade can get n and out fo tte o no cost.

Anothe advantage of these oducts fo oton tades s

the beadth of oducts. Tades that ae nteested n tadng

S&p 500, S&p 100, NASDAQ 100, russe 2000, ViX Futues,

O, Nat Gas, countes a ove the wod can nd a oduct to

tade. Most of these oducts have enough voume fo tades

to get n and out wthout ayng age ce bd-ask seads.

Ths eads us to some of the majo ssues wth some

of these oducts: the stuctue. Ask any tade that has

bought and hed a doube o te ong o shot, bought

voatty ETN, a commodty ETF, o any host of ETps and

they can obaby te you a stoy. Ths stoy nvoves hod-

ng the oduct and not undestandng what thngs ke day

etuns, o yed, o taget etun mean; ths s then

added to costs of the fund, and a sow move n the exected

decton. The concuson of ths stoy ends wth the ETp

owe than when the tade bought the fund deste the

undeyng beng hghe. it s even uge when the tade s

wong on decton o the ETp stays neuta. The tuth s that

thee ae SO many of these oducts, stuctued n so many

non-ntutve ways, a tade can thnk he o she s settng a

oston wth one bas when the tade moves wth a com-

etey deent bas. i ecenty saw ths haen on a ou-

a tadng show wth a natona oce, so dont smy thnk

that because os ae os that they get a of these od-

ucts . . . they dont.

The next ssue wth ETFs, and ths s one i want to focus

on, . . . the cost. One of the majo easons i dont tade a ot

of SpY stock s that because i get much bette bang fo my

buck usng the futues. Fo tycay ess than 2.50 a con-

tact a tade can buy o se one futues contact n the S&p

mn-contact the equvaent of 500.00 shaes of SpY stock.

Tycay 500 SpY shaes s gong to cost moe than 2.50 no

matte how good ones ate s, uness the tade s a fu-on

ofessona. That sad, tadng 500 shaes of SpY vs. ES s

not gong to be a HUGE commsson deence; t gets even

wose when ookng nto the cost of oton commssonsa

subject we w touch uon ate n ths ece.

INDEx OPTIONS

The most actvey taded oton n tems of notona do-

as taded back and foth n the wod s the CBOEs SpX

otonon any gven day cose to 100 bon doas n

notona doas can change hands. Smy a huge amount of

money n doas, ths can make the ndex an easy contact

to tade, and at the same tme be qute ntmdatng. i know

many a eta, and even nsttutona, tade that wont touch

the oduct.

The man eason many tades wont touch the ndex has

to do wth the maket. Unke the SpY and just about evey

ETF, most othe equtes, and even a few ndexes, the SpX,

NDX, rUT, and ViX, ae many oen outcy. Ths eads to a

tte ess caty n the maket, esecay fo those that dont

know the makets vey we, and a wde sceen maket. Take

the cosng maket of the ATM otons n the font month

May otons.

3.00 wde n an ATM oton can seem a tte scay and

tuthfuy t shoud be. Howeve, tades need to be awae

that unke ETF otons, ndex otons have an nsde ma-

ket. Whe that 3.00 wde maket mght be scay, the SpX t

woud be wng to take down at east 10,000 contacts at

those ces (i am not exaggeatng hee, they woud). The

nsde maket that s usuay about 1,000 u, s fo the most

at ess than .30 wde. Ths means that the SpX t s w-

ng to take down the equvaent of 10,000 SpY contacts wth

.015 away fom the medan ont. Ths s not somethng that

haens n font month otons, even n the case of the SpY.

Next, thee ae the tax mcatons. Whe we cannot

egay get nto many of the ues and eguatons of the tax

mcatons of ndex otons; ndex otons that sette nto

cash ae subject to the 1256 ue. Ths ue s what tades

ca the st stadde. Essentay the ot of the tad-

ng o of ndex otons s st between shot tem and ong

tem cata gans. Ths s vey beneca to tades. Whe

i woud ove to dg nto the detas, we cant doe out tax


Figure 1 An ATM bid-ask quote for SPX options


18/24


advce n ths magazne. if you ae an actve tade that

tades SpY, consut a tax ofessona; you ae key ceam-

ng you tax b on any money you ae makng.

Fnay, we come to commssons. Ths s, n my on-

on, whee ndex otons ke NDX and SpX cush the ETF

cometon. The NDX eesents about 40x the vaue of

QQQ; the SpY s about 10x the vaue of the SpX. Amost a

of the majo ndexes ae MUCH cheae to tade because

they eque much fewe contacts to tade. Take the NDX.

if a tade wanted to tade 100x the vaue of the NDX, that

woud eque the tade to tade 100 NDX contacts; assum-

ng a decent commsson stuctue, the cost of the tade

woud key be aound $75.00.

Now t woud be geat f bokes and the exchanges sad

that the QQQ beng a smae ndex shoud have a owe

commsson, o bokes assed though the contact fee m-

ts they get fom the exchanges n ode to defay the cost

of tadng QQQ. The fact s they dont. Whe the NDX was

about $75.00, the same QQQ tade wth the same sk woud

have a commsson cost of $3000.00!!! Any seous tade

needs to be awae of the commsson cost of tadng (few

tades ay ea attenton to t. Tades that want to be e-

cent, esecay f they ae tadng any sze, need to con-

sde commsson cost.

ThE SWITCh

Swtchng fom ETFs to ndex otons s not sme to many

tades. Tades that ae used to ETF tadng need take cae n

movng to the bgge ndexes (o futues otons fo those that

tade thngs ke USO). Geat cae shoud be taken; to he the

ocess i have eaed a checkst tades can foow to he

smooth out the ocess. Fo the eta ubc whch tades SpY,

take a ook at SpXpM, t has susngy wde makets.

Figure out the ETFs corresponding cash index.

Fo SpY ts SpX, fo QQQ ts NDX, etc. Fo some of the

te ong, doube shot, o some of the othe ETFs thee

may be no way to eceate the ETF n an ndex; n that

case ethe consde the vadty of the ETF o kee tad-

ng t. Fo some of the commodty-based ETNs and ETFs

take a ook at usng the futues otons, anothe majo

task, but usuay woth t.

Migrate slowly at rst. Trade no more than one con-

.

lke a othe thngs, dont jum n wth both feet. Stck a

toe n the wate and see whee t takes you. it s cometey

okay to send some sma amount of cata n ndexes and

keeng a huge oton n the ETFS whe you ean.

As you migrate learn whererelative to bid-ask

spreadyour trades are getting lled.

As i stated, SpX has wde makets but the nsde maket

s SUpEr tght. lean to use these tghte makets and

hoefuy do even bette than the bd-ask sead.

t .

Ty tadng OEX o XEO befoe tadng SpX. it s com-

etey okay to ck a smae ndex that coeates we

to an ndex you ae tadng. The ont s eanng.

Slowly increase size away from ETF into Index.

Agan, dont rush. Tme s aways on you sde as a

tade, and i have found that t s amost neve a gooddea to jum nto thngs.

Be smart in executing, neverhit a bid or lift an oer.

You caught the dscusson on the nsde makets, make

sue you heed that wod.

Tadng otons n genea s not easy. To make mattes

wose many an otons tade consstenty fas at beng e-

cent wth hs o he cata. One sma ste that tades can

take s to evauate the oduct that he o she s tadng n

ode to accomsh the task at hand. One thng we know fo

cetan s that tax savngs and commsson savngs contb-

ute decty to the bottom ne. We aso know that thee ae

no ndex otons that have doube, te eveage, stange

stuctues, and odd etuns. Whe thee s cetany a tme

and ace fo ETFs, most actve tades woud do themseves

a majo favo to nvestgate ETF tadng. EM

1 lveVopowww.vevo.com

http://www.livevol.com/http://www.livevol.com/


19/24


how Did We

Get here?Andrew Giovinazzi

Te Old Days

When i st waked onto the oton

tadng oo n San Fancsco i knew t

was fo me. Back n 1989, whee many

maket makes wee st shakng o

the cash ookng fo the second o

thd ound of backng, the oos wee

a vey aocha and exctng ace.

Not n the Chuch sot of way, but vey

oca. Amost eveythng was who you

knew and how you dd thngs. A new

tade coud max out the cedt cads,

deost money nto an account, take

a test and get gong. Today that s not

ossbe. Aso, the technoogy was,

we, not qute domnant yet. Oen

outcy ued the day. Essentay once

a oo tade oened the mouth the

quote showed u on the sceen o a

boke coud ht the bd. Eveythng

was ve fom the oen to the cose. As

the maket evoved, technoogy and

enty nto the makets wee the thngs

that have changed the most. i woud

ke to exoe those two onts and

the mact on ou cuent envonment.

Most of the tades i knew used

cadboad cads to kee tack of oton

ostons. That was the ea tme sk

management system. Ceang ms,

ke Sage (who aways seemed to be

one ste ahead fom what i saw and i

ceaed though them fom 20012006),

had etty good oston management

systems fo Geeks and sk but many

tades st eed on cads and contact

count backng out evesa/conveson

combnatons. Geeks and dynamc sk

wee smy caed sheets. Evey tck

n a stock ce had a vetca coumn

and tades coud ead the sheets and

monto ostons, theoetca vaues

and sk sem-ea tme. When i stated

makng makets n Febuay of 1991, i

was known as a sheet guy, somewhat

deogatvey. Amost fom the day i

waked on the oo i notced two thngs:

1.The ace of the change of tech-

noogy moved ady

2. Baes to enty to ovdng

qudty to otons makets ket

gettng bgge

At the tme my sheets wee a bg

ece of technoogy that used to take

a nght to un to eae fo the next

day. in a coue of yeas they woud

be avaabe n ea tme on handhed

comutes and most of the cad ead-

es had vanshed. Was that necessay

a good thng?

Canges in Quoting Tecnology

and Liquidity

The pSE n the ate 80s secazed n

what wee known as Q stocks. These

wee the names that taded on the

NASDAQ and n genea wee much

moe voate than the NYSE sted

stocks. The CBOE and AMEX taded

mosty the bg names and the ndex

oducts. What the pSE had to sove

was the voume of quote tac gene-

ated fom the bg movements n MSFT

(i know you augh but t was a move),

SUNW, DrAM and some of the othe

OTC names back then. The pSE aso

sted sevea Botechnoogy stocks

ke Genentech. These stocks taded at

much hghe voattes than the stan-

dad sted names. The oton qudty

tended to stay n one ace because

most of the names then wee sngy

sted. The makets on instnet, whch

was the domnant tadng atfom at

the tme, whee usuay .3 wde and

the leve 2 NASDAQ coud be .5 wde

fo the same name. Ths was my eay

ntoducton to qudty as a cek both

fo otons and stock. Wokng an

instnet machne was a quck esson

n whee the maket was and whee

t wasnt. The obem then, as now,

was whee the sze was. Much of

the tme thee was a hdden bd o

oe that you had to know was thee.

That nsted the ess that qudty s

sze (voume) at a ce and not just

voume.

As the numbe of stocks and

stkes ket exandng (fees ke they

doubed evey yea) the oe of the

qudty ovde (maket make) had

to kee ace wth the gowng sze

and ace of the makets. When i st

stated i managed 15 o so ssues and

t was a handfu. By 2000 i was man-

agng 50 o so names and auto quotng

technoogy had taken ove fo oen

outcy on a exchanges. it was at ths

ont that tades needed technoogy

just to kee u. Wthout t, they wee

behnd the eghtba. The technoogy

cost assocated wth ovdng qudty

ket gettng hghe too. The guy wth

the cedt cad account coud no onge

aod to comete.

Fractions to Decimals

The seed of quotes unnng nto OprA

(Oton pce reotng Authoty)

f l o o r s t o r i e s


20/24


have been gowng at a ate i coud

not magne back n 1989. The agest

change to both qudty and maket

stuctue was the decmazaton of the

maket n the eay 2000s. Knowng

how to add and subtact factons used

to be a necessay sk. Moe mo-

tanty, decmas eaced the amount

maket atcants coud ean on

each othe. Fo exame, f a tade

osted a bd fo 100 contacts, n

the od days anothe aye woud

have to bd 516 to ste n font of ma-

ket. The sk was aound .065. Now

wth .01 makets the sk s amost

neggbe. That s a bg ste. Ths

change haened to makets on a

oton and equty tadng oos and i

beeve was a bg foce behnd mov-

ng qudty o of the od exchanges.

it became vey had to move sze

when anothe atcant can jum n

font wth .01 (o ess) and kee the

age nsttutons fom gettng ed.

postng qudty had vey tte ben-

et. Moe and moe ae s matched

o the oo, and whe thee s vo-

ume, thee s not necessay qudty.

What ths meant fo the maket mak-

es s owe magns fo otons and

moe factued oton voume snce

the oo became moe of a quotng

and cossng venue. Fom the 15 ot

ubc ont of vew, ths was seen as a

bg us as the cost of tadng otons

went down. lqudty stated to dan

fom the system, abet sowy.

hig Frequency Trading (hFT)

it s funny to thnk about the equty

oton tadng wod now as oosed

to not vey ong ago. The exchanges

but gant es to un data nto and

out of the eotng systems and the

oetay tadng wod gued out

ways to them u. i dont eay have

an axe to gnd about HFT snce the

makets have been movng that way

fo qute some tme. When the baance

shfts to just technoogy domnance

of the bggest ms, as oosed to a

baance of qudty, maket makng

and technoogy, the maket nds tsef

n ts cuent state. Smae bocks of

qudty ae extng the maket, ue

and sme. A way to get back n some

knd of baance s to eque ms that

geneate quote tac to ovde some

knd of ea qudty n the maket.

Foo tades wee obgated to

make a maket whe they wee stand-

ng n a cowd. Membes had to ovde

some qudty dung cashes, take-

oves and whateve maket events

haened that day. As the maket

moves unceasngy n one decton

of faste, ess qud and moe voate

tadng t s obaby tme to take a

ook at what s needed to bng qudty

back n. We shoud make what we have

wok bette befoe we add yet anothe

tadng oo to futhe factue the

qudty that s aeady thee. EM

how Did We Get here? (continued)

The exchanges but gant es to undata nto and out of the eotng systemsand the oetay tadng wod guedout ways to them u.
http://vixandmore.blogspot.com/


21/24


itistimeonceagainfo what i ca a oof-of-con-cet tade. Snce i aey tade otons n the majo maket

ndces, ths months Foow that Tade seemed ke a good

tme to take some of the deas that coed u esewhee

n ths ssue n Comparative Implied and Realized Index

Volatilityand tun them nto a tade.

Background and Rationale

in my atce on med and eazed ndex voatty, i noted

that snce the begnnng of 2009, the rUT (russe 2000

index) and rVX (CBOE russe 2000 Voatty index) a has

consstenty demonstated the owest voatty sk emum

(Vrp) among the majo maket ndces, whe the SpX (S&p

500 index) and ViX (CBOE Voatty index) have geneated

ethe the hghest o second hghest n each of the ast

thee yeas. The atonae fo ths tade s sme: ay the

Vrp deenta game by gong shot SpX staddes and ong

rUT staddes n the same notona amount.

Setup and Entry

Havng estabshed a bas n favo of shotng SpX stad-

des and gong ong rUT staddes, i seached fo a setu n

whch the ViX was consdeaby hghe than aveage ea-

tve to the rVX than t has been fo the ast eght yeas. As

t tuns out, thee wee a numbe of nstances that fe nto

the categoy of a hgh ViX eatve to the rVX fom August

2011 though the begnnng of Januay 2012, but dung the

ast thee months these eadngs have hugged the hstoca

mean tghty.

Whe i had evey ntenton of watng fo a age ske

n the ViX eatve to the rVX, fatgue and oweed exec-

tatons nay got the bette of me on A 10, when the

ViX:rVX ato ht a two month hgh, even though ths hgh

was ony n the 59th ecente of data fom 2004 to the

esent.

i seected ATM staddes fo the month of May, oundng

u to the next stke n both nstances. At the cose on A

10, the rUT was at 784.15 and the May 785 stadde was

50.65; the SpX was at 1358.59 and the May 1360 stadde

was 62.80. So that the notona doas wee aoxmatey

equa, i bought 10 contacts of the rUT May 785 stadde

at 50.65 and sod 8 contacts of the SpX May 1360 stad-

de at 62.80. Kee n mnd that whe the eatve ostons

ae fay age ($50,650 fo SpX and $50,240 fo rUT), the

actua doas at sk n ths tansacton s eatvey sma,

gven the hstoca coeaton of .985 between these

two ndces.

Position Management

in managng ths tade, i ad atcua attenton to the

decton of the moves n the ViX and the rVX as we as the

magntude of the changes n the two voatty ndces. My

assumton was that wth both voatty ndces sghty

eevated eatve to the ecent anges, the most key

scenao was that both the ViX and the rVX woud decne

and the tade woud be a wnne f the decne n the ViX

woud be abe to kee ace o amost kee ace wth the

decne n rVX.

April 11rght o the bat, both voatty ndces

decned, yet the net vaue of the oston decned $12. Ths

s an eay wanng sgn, but ony a md one at ths stage.

April 12Fo the second day n a ow, the equty ndces

ose and the voatty ndces decned. Today thee was a

bg deence n the magntude of the moves n the voatty

ndces, wth the ViX fang 14.1% and the rVX fang ony

8.2%. My hyothess was that a move ke ths shoud geaty

enhance the otabty of the tade. instead, the oss gew

fom $12 to $27 and age wanng ags went u.

f o l l o w t h a t t r a d e

Long-Sort Straddles on Two

Major Market IndicesBill Luby

i ke to thnk of my otonsstateges . . . as a otfooof stategc exements on

the magn.


22/24


April 13Ths tme the equty ndces fe and the voa-

tty ndces ose. The good news s that the staddes, whch

have come to be domnated by the vauaton of the ut eg,

have nay sed beow the oenng ces and fo the

st tme the net oston shows a ot: $26.90.

April 16Mondays tadng favoed the rUT, wth the

rUT sng and the SpX fang. The ViX was unchanged, but

the rVX ose 1.7%. Both stadde ces contnued to decne

and the ot gew to $44.40.

April 20Wth both equty ndces u ony 0.7% fo the

week, t has been a eatvey sow week. Both voatty nd-

ces, howeve, have decned shay fo the week, wth the

ViX down 10.8% and the rVX down 9.8%. The steady decne

n voatty exectatons has gaduay eoded the vaue of

both staddes, wth the rUT stadde down 12.64% fom ts

oenng vaue, whe the ViX has decned 18.15% fom ts

oenng vaue. The ot n ths tade s now at ts hghest

eve snce the tade was oened: $155.20.

Ths s the esut that i had hoed fo and fo that ea-

son, i beeve t s tme to take at east ata ots, f not

cose out the oston entey. As ths s st and foemost

a oof-of-concet tade, i w contnue to eave the edge

oen on ths tade and see how t deveos dung the na

fou weeks o to exaton. At ths stage of the game, i

exect the educatona vaue of montong ths oston fo

anothe fou weeks to be moe motant than the otenta

ots that can be wung out of t. Shoud some atcuay

nteestng nsghts come out of ths, i w evst ths tade

n a futue ssue.

Epilogue and Takeaways

pat of the eason i ke these oof-of-concet tades s that

they foce me out of my comfot zone nto aeas of tad-

ng wth whch i tycay have ony some mno fama-

ty. in the case of ths comaatve voatty stange, i see

a need fo stategy anaytcs (evauatng how ths tye of

tade woud have efomed n the ast and adjustng the

ues fo entes and exts as aoate) to be combned

wth actua one-o oof-of-concet tades such as the one

outned above.

Of couse thee ae huge sks n geneazng fom

one sma set of data onts, but i ke to thnk of my

otons stateges not necessay as a xed set of tadng

aoaches that have the best backtested and/o ea-wod

esuts, but athe as a otfoo of stategc exements on

the magn. poof-of-concet tades ae one way of me-

mentng those stategc exements whch often ovdes

vaued feedback on a cuent stategc focus o onts the

way to new stategy deas.

in the case of SpX-rUT staddes, i thnk the voatty

sk emum and eatve voatty aoach has some

met and anothe ound o two of stategc exements s

waanted. EM

Long-Sort Straddles on Two Major Market Indices (continued)

Figure 1 SPX-RUT Straddle Summary


23/24


hedging

MiciganEric Kovalak, Guest Contributor

sometimeago, afte a day ofdstoted voatty cuves and eatc

ce movements, a fend of mne

asked why i enjoy tadng the ma-

kets. Afte oeng hm a monoogue

of notons few coud beeve, the tuth

wasts a hedge aganst eveythng

ese. Successfu tadng may om-

se savaton fom job ntevews, ong

commutes, and the osect of some-

one ese dectng you nanca futue,

but at the end of the day, many tad-

es ae wokng towads the concet

of a otabe hedge. The ast decade

has gven us good cause; tech and

housng bubbes, nanca coases,

cuency naton, and fo me, a hedge

aganst my home stateMchgan.

Mchgans economc woes began

n a evous geneaton. Most eoe

vstng the Moto Cty today neve

exeenced the ntewa goy days

whch made Mchgan a mdway sto

fo Boadway efomes taveng

fom New Yok to los Angesthats

ght, Gandma Nostaga s st bak-

ng cookes. Fou ane oads wee

once so congested one woud avod

them befoe sundown, but by now

as exeenced n Octobe 2008you

coud hod a chess tounament unde

the stoght. Wa Steet had lehman

Bothes, Countywde Fnanca, and

otentay the Fedde and Fanne

twns; Mchgan had Genea Motos,

Chyse, and eveyone was hod-

ng beath fo Fod. Eveywhee ae

emndes of Detot, Fnt, foecosue,

and economc destucton. Yeas of fo-

egn cometton matched wth the de-

ndustazaton of Ameca have gven

Mchgan a eutaton as a one-state

ecesson, and ths s easy suoted

wth a GDp gah that beongs n the

mogue.

The Mchgan stoy causes one

to check fo buet hoes ke they

just eayed a tck chat of the Fash

Cash. Take a dee beath, wee st

hee. Mchgandes now eaze that

no matte what the futue bngs,

we wont be foced to eat the fam-

y et. And no matte what decton

the DJX tades, thee emans sgn-

cant ootunty n tadtona econ-

omy and vaue added busnesses. it

s unkey that Ameca w eve agan

exeence the vast dsaty between

domestc and oveseas manufactu-

ng cost as Mchgan has weatheed fo

the ast 30 yeas. And unke a ty-

ca Easten Boc state, t teas down

the od as qucky as t buds the new.

Mchgan s movng on, but s t makng

the best tades?

i have aways had a sense that a

genuney wokabe tadng stategy

woud at tmes, n the ght envon-

ments, aow you to go and take the

meat out of the maket. These ae

the ootuntes whee fo the same

o ess sk as usua, you can exess

n ea tems a geate exectaton

fo the outcome. Hee the tade has

a comettve advantage though

stategy, and secc choces set hs

ostons aat fom the othewse e-

etua constant of ecent makets.

it aso means fo many, the abty

to oeate n the coe of the ma-

ket nstead at the ehea, tadng

at-the-money. if the goa s to execute

n sze, ts sometmes dcut to ut

money to wok by ckng u nckes

aound the edges.

Ths shoud be a esson fo

Mchgan. its ace cad s one ts been

ayng fo yeasso ong as the geo-

gahca beauty and cutua sound-

ness of the state make t a ace

that eoe want to ve, t w be

escued fom the thoes of a eet-

ua economc and mgatoy eces-

son. Coege students w eave to

make the fotunes and eventuay

etun home, and the success stoes

of Chcago w buy watefont homes

just noth of the bode. These hoes

ae akn to seng out-of-the-money

uts. if the tade ends u ownng the

stock, thats ne, but hes eay ho-

ng to smy enjoy the vew. Coasta

states such as Cafona and New Yok

ecenty eoted a contnued exodus

of the squeezed mdde cass. in con-

tast, Mchgan s exeencng an ext-

bound stamede of the cata ntense

B a c k p a g e

The Mchgan stoy

causes one to

check fo buethoes ke theyjust eayed a

tck chat of the

Fash Cash.


24/24

hedging Micigan (continued)

Ask te xperts (continued from page 5)

enteeneua cass. losses can be

found by measung evey asset fom

bans to bank accounts, and whe

wndow dessng moves the sunset,

the state s n de need of eoe who

emembe how to tun on the ghts.

Ctzens want to beeve the state

s not entey asee at the whee.

The Mchgan Economc Deveoment

Cooaton has dstbuted mons n

fundng to oject secc causes ho-

ng to su the veocty of money, and

oca nvestos n a majo ctes have

steed u to the ate by ecom-

mttng the goas to be deveoed

cose to home. These ae exceent

cheeeades, but too often oganza-

tons wthn the state ty to chamon

secc otons of the economy, and

ths s sma to seng out-of-the-

money cas uon ts futue. The State

of Mchgan and ou Ctzens need to

thnk ke a seous tade: whats ou

edge, and whee do we need to tade

to once agan become a seous a-

tcant n the maketace. EM

Eric Kovalak is an active options trader

and resides in Grand Rapids, MI.

of can dvege fom tme to tme. Of

couse the Set futues move much

ess faste (3040% of the font month

futues, on aveage), so as a hedge

they shoud obaby be aox-matey 3x the sze of the font month.

The bg ssue i have wth these s

that f thee s a ske n A voa-

tty just befoe the exaton, the

As w move amost as qucky

as the ViX and the Setembes may

move ony 2030% as qucky, so to

have a easonabe chance at man-

tanng a oe hedge, the sze of

the Setembe oston shoud gow

the cose we get to exaton. Eventhen, thee s no guaantee that the

Setembe oston w be a oey

szed hedgeany moe that thee s a

guaantee that the 6th month futues

w move n the same decton (not to

menton at a edctabe ato) to the

font month futues.

When thnkng about ths ssue, i

aways have ths ViX futues chat n

the back of my head that shows the6th month ViX futues movng 10% as

qucky as the ViX and the 8th month

futues movng ony 3% as much as the

ViX on a day when the ViX sked 64%.

B
http://vixandmore.blogspot.com/2007/05/vix-futures-one-picture-to-remember.htmlhttp://click.linksynergy.com/fs-bin/click?id=ymUAlcp2j7I&offerid=145240.10000059&subid=0&type=4http://vixandmore.blogspot.com/2007/05/vix-futures-one-picture-to-remember.html

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