Managing Positions Pre- and Post-Trade at RMC

The second presentation at the 29th CBOE RMC has David Mitchell from Bloomberg and Michael Schmanske from Glenshaw Capital Management discussing Managing Positions Pre- and Post-Trade. The presentation began with a quick review of option risk measures, followed by a discussion of scenario and horizon analysis. They finished up with examples of managing option positions over time.

One of the first interesting points made during the presentation talked about determining whether implied volatility is rich or cheap — it’s all relative to realized volatility and the current market environment. “Volatility can be ‘low’, but it may not necessarily be cheap”.   To illustrate this point, David Mitchell uses changes in equity option implied volatility before an earnings announcement as an example of where using recent volatility to determine if implied volatility is rich or cheap may not make sense. 

Implied correlation of stocks that are members of an index also has an influence on volatility analysis. The more correlated the individual stock price changes are, the more volatile we should expect the index performance to be. A good question was raised about macro events having an impact on correlations and the performance of the stock markets. It was noted that when correlations begin to break down or move lower, it is bullish for the stock market as it shows individuals are more comfortable buying stocks without concern for the overall market direction. Keep in mind the CBOE publishes implied correlation indexes –

The first case study presented was based on equity skew. Skew exists in equity options where out of the money put options often have higher implied volatility relative to options with strike prices closer to the underlying market as well as call options that are out of the money to the upside. The case study used data from July of last year when the skew was much higher than it had been over the previous few months. The trade suggested was to initiate what was called a “skewed put condor.”   This version of the condor involves buying a put option that has a strike price lower than the short put in the condor relative to the distance between the short and long call options that make up the spread. A benefit here is you are capturing skew without having to take on the risk that is associated with a naked short option position. 

The second case study showed a situation where a 1 x 2 Call spread may be appropriate. From May of 2012 – with the S&P 500 at 1350, implied volatility was in the 18’s, higher than where it was last time the S&P 500 was around those levels. In order to take advantage of the ‘rich’ volatility, a two-month 1350 Call is bought and two two-month 1400 Calls are sold. The idea here is for volatility to grind down as there is a controlled rebound in the overall stock market.  

A statement I found interesting was to think of volatility and time to expiration as the same thing. For example – the more time to expiration or the higher volatility – the higher the option premiums. Conversely – less time to expiration or less volatility – the lower the option premium. 

With respect to understanding conditional risk profiles it was noted one should –

1. Recognize an options portfolio is dynamic and the goal is to create limited loss scenarios that can be actively managed and used as efficient trade vehicles.

2. Consider what the expected move would be in implied volatility given different price movement scenarios.

3. Consider the impact of time on the options positions. Determine whether the position should be unwound, rolled, or otherwise hedged. 

A question was asked about the market moving higher and implied volatility moving up at the same time. The response was typically volatility will not rise in a rising market, but when volatility is flooring, this may be a concern as it may not have much lower to go. It was also noted that out of the money call options may have very low implied volatility and if the stock market moves higher and closer to the strike price of those calls the volatility of those options may actually rise. 

There was discussion how the implied volatility of equity options behaves differently than the implied volatility of index options. Large moves to the upside are more likely in individual stocks relative to market indexes. Option skew adjusts for this when comparing equity to index options. 

The final statement that capped on the presentation was relative to VXX which was called one of the most remarkable changes in the equity trading world in years.