Options expiry week, fairly lackluster as usual now. The days of huge volatility on expiry weeks seems to have gone.

A gap open of +712%. Pretty much, that could wipe you out if you were ‘short’ via common stock. Always safer, if going short, to go short by being ‘long’ a Put Option. Your losses are capped at the debit of the purchase price. Options have their own risks, but they do control this type of risk.

However, there was very strong call option activity in the stock on Oct. 14, specifically the Oct 1.5 which traded over 12,500 contracts against an open interest over 7,500. This is very bullish when we see that this a full 20% above its closing price and the option just closes in 5 business days.

Moreover, what may be even more impressive is that the call option more than doubled while the stock moved in the opposite direction closing down 3%. This undoubtedly shows strong conviction by at least some group of investors having the right to buy 1.25M shares for the next week at $1.50 that some strong upward movement in EK is likely to happen this week.

The recent volatility has created an interesting spread twixt Implied and Historical, with historical higher than the implied. There are various Option strategies designed to trade this spread.

An Option trade strategy, or rather strategies, explained by this lassie.

Now I’m not going to bother detailing the really basic analysis of Option trading, which is so incomplete and lacking, that it is pretty worthless for all but the rank beginner. However if you want to read it, it is here

Of much more interest is that the article really is nothing more than a plug for a methodology, or rather an indicator is a more accurate description, which is detailed below. I shall read through it and make comment later.

Overview of Expectational Analysis

An Introduction to Expectational Analysis

The slightest edge. That’s what every trader looks for. But there’s no Holy Grail that guarantees success in trading and investing, and the fickleness of the market guarantees there probably won’t ever be one. However, our unique methodology provides a leg up on the competition.

At Schaeffer’s Investment Research, we’ve found an advantage in an area that until recently was generally considered nothing more than hocus pocus – sentiment. When combined with fundamental and technical factors (a 3-tiered methodology we call Expectational Analysis®), sentiment becomes a powerful tool for analyzing stocks, sectors, or the overall market.

What exactly is sentiment analysis and why do we consider it so important? Investor sentiment is simply the collective feelings, moods, beliefs, (and in some cases actions) of investors (from the smallest individual investor to the supposed “smart money” of institutions). The most accurate sentiment indicators generally reflect what a group of investors is actually doing as opposed to what they’re feeling and saying, although the latter also has a degree of validity.

There’s no such thing as an infallible indicator, and sentiment is no exception. But without a feel for the expectational environment surrounding a stock, analysis (be it technical, fundamental, or a combination) is simply not firing on all cylinders. Very often it’s the expectational – or sentiment – backdrop that makes the difference between a good market call and a bad one.

For example, it can be a puzzle as to why a stock declines despite an earnings report that met (or even beat!) Street expectations, while another equity rallies strongly after simply meeting expectations. In this and similar situations, what could possibly be the explanation?

The answer is often contained in the differing expectations surrounding the pair of stocks prior to the event. In the case of the former stock, the sentiment may have been excessively bullish heading into the report, making the shares ultimately vulnerable to disappointment. There could have been a build-up of call options or a lot of anticipatory buying of the stock, which then becomes exhausted by the time earnings are reported. Such a high-expectation environment creates a heavy burden on the stock to issue a blow-out earnings report.

For the other stock, there could have been a prevalent concern about a company’s fiscal health and some expectations that earnings might fall short of the mark. The result? Increased put buying and shorting activity, which is eventually unwound should the company exceed lowered expectations.

Why are expectations so important? Because the price of a stock represents investors’ perceptions of reality and often these perceptions are excellent contrary indicators. A stock with relatively low expectations stands a good chance of rallying, as the price will rise from this artificially low level to one that reflects the “real world.” Conversely, high expectations can put downward pressure on a stock, as the price adjusts itself lower from its unrealistic heights to better match reality.

Put another way, low expectations translate into potential buying power, as skeptical investors (and their money devoted to investing) wait on the sidelines, ready to bolster a stock’s appreciation by buying up the supply from profit-takers. This excess demand drives the price even higher. On the other hand, high expectations usually mean that much of the sideline money has already been committed to a stock. Buyers are now scarce and selling will predominate on any perceived negative news, leaving the stock more vulnerable to a significant decline.

One of the most important tenets of our Expectational Analysis® approach is that the power of a contrarian indicator is much greater when the underlying sentiment runs counter to the direction of the stock. For example, pessimism would be an expected reaction to a downtrending market and would therefore not be a valuable contrary indicator. On the other hand, skepticism in a rising market is a powerfully bullish combination, as market tops are not seen until optimism reaches extreme levels.

Investors are normally quite bullish during bull markets and quite complacent and relatively lacking in fear on pullbacks in bull markets. It then becomes an art for the sentiment analyst to determine when this bullish sentiment has reached an extreme, at which point buying power will have become dissipated to such an extent that the market will top out. But when negative sentiment accompanies a bull market, the task of the “sentimentician” becomes much easier, as it is thus clear that buying power has not yet been dissipated and that the bull market has farther to run before potentially topping out.

True Expectational investing does not mean simply buying a stock or index because no one likes it. By some definitions, a “contrarian” investor would simply scoop up out-of-favor securities, but just because stocks are out of favor doesn’t mean they are on the verge of a rally. In fact, negative sentiment is certainly warranted on poorly performing stocks or sectors, and if a stock is displaying weak price action, there may certainly be a reason for it. Negative sentiment alone is not enough to predict when a stock will turn around, and positive sentiment is not enough to gauge when a stock may start to roll lower. After all, even exceptionally depleted selling strength will keep a stock moving lower as long as it exceeds the comparable buying strength.

An objective look at sentiment indicators – including short interest, option activity, sentiment in the press, and analyst ratings – can add substantial value to traditional technical analysis, because sentiment extremes are not visible on the charts and can only be viewed and measured by a separate class of sentiment indicators.

A trend that is nearing its conclusion cannot be distinguished on a chart from a trend that has a long way to go in price and time. In fact, there is an old saying in technical analysis to the effect that “the chart looks prettiest just ahead of a top.” But sentiment indicators can help you distinguish the pretty chart that is going to remain pretty from the pretty chart that is about to turn ugly.

In the papers, on the financial news networks, and on financial websites, the term “sentiment” is cropping up more and more frequently these days. We take this as a broad sign that analysts are finally beginning to admit that there is more to the stock market than just fundamentals and technicals – something Bernie Schaeffer has been shouting since 1982.

The true pioneers of Expectational Analysis®, Bernie and his research staff have tested and developed many qualitative and quantitative methods to evaluate sentiment. The distinguishing difference is that indicators used at Schaeffer’s Investment Research do no reflect only the overall market, but individual sectors and stocks as well. Read on to learn about some of these sentiment indicators and how they can be used to improve an investor’s trading results.

Supposedly a very volatile day. Well not in AUY, which continues to nap rather frustratingly at the level [range] that has dominated for about five weeks now.

Ok, I know it’s tomorrow, that its quadruple witching, but I’m in NZ, and it’s already Friday!


From sigmaoptions, this post appeared discussing mental competencies. In a first part response, I’ll look at the Greeks component. In the second, I’ll consider the actual neurological pathways involved, and why in this example, unconscious is a misnomer.

An illustration of this point came up on a discussion forum recently. The question was asked, can you be successful without regard to the Greeks? Various points of view were put forth, but the one that interested me was from an ex-institutional trader with decades of high level experience. He thought that Greeks were not necessary for simple directional strategies.

The Greeks in Options delineate mathematically characteristics of Options as they respond to the underlying asset class from which they are derived. Unless you are a pretty competent mathematician, they are not really intuitive, which is why prior to the Black-Scholes-Merton model, they were traded seat-of-your-pants style, as there were no Greeks

I had an interesting [now] experience with AAPL Options and their earnings, that was entwined with IV. In short, the IV rose prior to earnings, and dropped after earnings, which limited [seriously] the expected return.

Returning to the quote. Yes, an experienced [decades] trader would realize that IV would most likely ratchet higher, as MM sought to insulate themselves [gouge the retail trader] from a positive response to an earnings announcement, but calculating that jump in IV without a model would require some serious cognitive gymnastics.

From this trade you can calculate the IV was 44% on purchase [Black-Scholes model] The day after, I sold at approximately $158.00, IV had crashed to 27%, hence the selling price

This was a simple directional strategy. The strategy and direction both turned out to be correct, yet, the payoff was sub-optimal, due to the Greeks being manipulated. I was aware that it may happen, I knew the IV prior to taking the trade, and still got hosed after the MM dropped the IV.

Would our trader know, or expect a 50% drop in IV? Would he calculate mentally the fair price based on the Greeks for the Option? Would he have known that at purchase price, that gamma was at it’s peak, and would decrease? That vega was also at it’s peak and would decrease? Possibly. By looking at the bid/ask spread, you will get an idea. But he [trader] would be advised to consider historical volatilities in contrast to the current volatility. He might then consider, based on earnings being a one hit affair, that volatility being currently elevated, might well fall back to HV after the event. HV is not a calculation that can be visualised on a chart however. You can look at two charts and observe that one is more volatile than the other, but quantifying that difference is not visually possible. Therefore, consideration of the Greeks becomes a necessity.

How about Gaussian distributions? ITM at 48.7%? Probability to expire worthless at 51.3%? Probability price between $155/$160 at 13.8%? Which is counter-intuitive to the high IV.

My point is this. It is unlikely that even trading a basic directional strategy, that knowledge of the Greeks is not required. Additionally, calculating the Greeks is hardly mental math. Thus, trading without consideration for the Greeks which seems likely, can be successful, but you may take trades that are potential horror stories waiting to happen unless you perform some analysis.


A couple of Options Traders have weighed in with the same answer. WayneL of sigmaoptions talks about frequency or what is commonly referred to as probability, combined with the dollar amount that is won or lost.

Never a truer word said. Probability of win is irrelevant on its own.

The expectancy equation has two parts, 1) probability of win and 2) win size vs loss size. One way of expressing this mathematically is with this equation:

Expectancy = ((1 + reward/risk ratio) * win/loss ratio)-1

Dean also confirmed the same thinking I have basically the same answer, save for a couple of further thoughts.

Probabilities, or frequencies that are calculated via Black-Scholes, Binominal Tree or even the more esoteric methodology of GARCH, all essentially utilise a Gaussian distribution of stock prices in their volatility calculations.

This as the old saw notes, generally works well, until it doesn’t. Mandelbrot created a new mathematics to deal with this [and other problems] which while obviously genius, doesn’t as yet offer much practical help in calculating probabilities.

Thus, calculations of probability via the previously mentioned models use the lognormal distribution of the historical data. The future is however what we are interested in. With lognormal distribution data, 2 Standard deviations captures some 98% of the data.

Fat tails describe the data that falls outside of this 2 Standard deviations, and when selling Options, these are the data points that can basically destroy your trading account.

An 8 Standard deviation move has a probability of 0.000000000000000629 In other words, this should only crop up once in the life of the universe. You could, on this basis, bet the Bank, [as the Bankers have done] and sell Options, of course the premium you would receive for being this far out of the money would be pennies and in addition, you might have to add a time component to the deal to allow it to exceed brokerage costs.

Of course, what that tends to do is the following: it brings the sellers of premium in closer, talking in a Standard Deviation manner, to the ATM Strikes, say, 3 Standard Deviations, although, more likely to the 2 Standard deviation envelope.

Now the sellers are exposed. Just what really happens in the market? Let’s look at some historical examples from 1999


Taking a low VIX day: July 25 1993, on that day 12 stocks had, or exceeded 4 Standard Deviations, major stocks, US Steel, Bethlehem Steel, Chiquita Brands being amongst the stocks involved.

Last September and October in 2008, we saw volatility jump to unprecedented levels, moves in excess of 2 Standard Deviations happened daily, for weeks at a time.

In summary, selling premium, exposes you to the possibility of really large losses from two sources: the first is the movement of stock prices that significantly exceed their historical probabilities expressed in lognormal distributions, the second being the jump in Implied Volatilities as quoted by the market makers.

Last year especially, the spreads opened up to 50%+ on the bid/ask on pretty much any Option you care to name. This pretty much always happens during a high market volatility period. The result is that even if you think that you can roll out of the trade, the spreads will pretty much kill that proposition for you. You of course might not have any choice in the matter – however this is basically a Martingale system and requires extremely deep pockets, notice however that it again is predicated on a lognormal distribution.

Margin calculations on naked selling are nasty. Margin calculations on a losing position, requiring the ability to roll – are nastier still. I was involved funnily enough in a real time discussion about this very question, viz. selling premium is a high probability event based on the fact [alleged] that 90% of Options expire worthless. It became quite an acrimonius discussion, however, he [the seller] was caught in a 6 STD move and was wiped out. This was not some BioTech stock, rather it was the FTSE index.


So circa $180K to hold a small loss of about $300 [original figures are in Pounds Sterling] For a retail trader, this is just insanity. The figures come from the previous discussion that I mentioned, once the market started to move against the position.

In summary, selling premium is very risky. I’m not saying don’t do it, simply that you cannot via any of the current models calculate the probabilities of the trade. What you can calculate however is the risk/reward ratio if you assume bad market conditions. That is ugly.


Couple of posts around the blogosphere regarding the Selling of Options First one

What isn’t a theory is what we can observe happening time and again. This is why, at PSW, we primarily SELL options, not buy them. Buying options is gambling, selling options is a business! I often point out to members that options is the game in the world where you can be the “house” with no disadvantage. In Las Vegas, you can bet with the house but they still have an edge but in options, there is no edge and day’s like this remind us why selling options beats buying them – not EVERY time but certainly OVER time.

Our last option expiration day was June 19th and I will give you today’s levels to watch because they are the levels of June 19th: Dow 8,540, S&P 921, Nasdaq 1,827, NYSE 5,934 and Russell 512. All the markets have to do to take out the calls sold that day for a nickel or a dime is to hit those levels at some time today. Of course, anything within 2.5% of those numbers is fine to as you can roll the calls you sold to the next month at no cost, collecting another premium for another month. This is the centerpiece of our Buy/Write strategy, which we discussed last weekend and I will be putting up a new Buy List for Members

Second one

90% Of Options Expire Worthless

In the previous post, the quoted “guru” stated unequivocally that 90% of options expire worthless, wit the implication that option sellers have an edge over buyers… actually it’s often explicitly stated.

According to the Chicago Board Options Exchange, typically only about 30% of options expire worthless in each monthly cycle. Only about 10% of options are exercised during each monthly cycle, usually in the final week before expiration. In fact, over 60% of all options are traded out in the marketplace. This means that buyers sell their options in the market, and writers buy their positions back to close.

So we see that the “90% of options expire worthless myth” is… a myth.

The fact it that there is no inherent edge in buying or selling options at point of inception, if they are correctly priced. It can be determined in retrospect, but the problem is that we cannot see into the future. There is no way of knowing whether the option premium is cheap or expensive, because we don’t know what the underlying is going to do.

I like being nett short premium, because I am better at managing those positions for more consistent profit, but it does not mean being nett long premium is wrong. Each has it’s own set of management implications.

Horses for courses.

A conundrum. I was also involved in a lengthy argument probably a couple of years back on this very subject. I’ll state my bias, that is I actually side with the second opinion, however, I’m going to revisit this topic as the first poster seems fairly legit and switched on, which is why it caught my eye in the first place.

Just to preserve the data. From SPY July Expiry [selection] Calls. The OPEN INTEREST is the last number.

89.00 SZCGK.X 4.95 0.15 4.80 4.90 2,878 60,249
90.00 SWGGL.X 3.80 0.20 3.75 3.85 4,978 99,116
91.00 SWGGM.X 2.80 0.35 2.79 2.84 12,253 60,942
92.00 SWGGN.X 1.85 0.29 1.80 1.82 14,109 71,964
93.00 SWGGO.X 0.85 0.49 0.80 0.86 31,087 71,366
94.00 SWGGP.X 0.05 0.65 0.07 0.08 71,712 76,161
95.00 SWGGQ.X 0.01 0.23 N/A 0.01 68,879 163,399

And the PUTS

87.00 SZCSI.X 0.01 0.01 N/A 0.01 252 100,218
88.00 SZCSJ.X 0.01 0.00 N/A 0.01 196 158,346
89.00 SZCSK.X 0.01 0.01 N/A 0.01 666 104,628
90.00 SWGSL.X 0.01 0.01 N/A 0.01 3,499 221,370
91.00 SWGSM.X 0.01 0.04 N/A 0.01 34,606 123,820
92.00 SWGSN.X 0.01 0.11 N/A 0.01 25,415 102,528
93.00 SWGSO.X 0.02 0.24 0.01 0.02 75,526 82,553
94.00 SWGSP.X 0.28 0.33 0.27 0.28 74,910 55,416
95.00 SWGSQ.X 1.16 0.10 1.18 1.24 11,544 21,728
96.00 SWGSR.X 2.26 0.26 2.16 2.23 2,234 7,416

Of course immediately we have a problem, how to segregate the OPEN INTEREST into bought and sold contracts.

From the Wall St Journal

The options market has become an expensive place to do business in recent days, and that could be contributing to wild swings in the stock market.

The options market often serves as a buffer to the stock market, providing a venue for investors to protect their stock portfolios or speculate on future moves without actually buying or selling stock.

In recent days, however, the prices of options have skyrocketed — in part because volatility in the market has flown off the charts. Options that once traded for a few dimes now cost more than a dollar, or even several dollars. And that’s especially true for put options, which are bearish contracts that convey the right to sell a company’s stock at a fixed price.

As a result, investors who would normally buy puts to protect their stock holdings might be opting to sell their shares altogether. It’s almost as if they realized their monthly car-insurance policy went from $100 to $1,000, and they decided to simply sell the car as a result, says Randy Frederick, director of derivatives with Charles Schwab & Co.

“Investors are concerned and want to hedge their positions,” Mr. Frederick said. “But when the put options that you would’ve normally bought now cost two and three times as much, the puts become very unattractive.”

The same goes for traders who buy options to speculate on future swings. As the prices of options become more expensive, the traders who want to position for a drop lower now look instead to sell stock short or turn to exchange-traded funds, like the ProShares UltraShort Financials (SKF) fund, that pursue similar strategies.

At the end of the day, that means there could be an influx of new players flocking to the equities market. That helps to propel the dramatic swings that investors witnessed Friday, when the Dow Jones Industrial Average plunged 600 points and then popped back up within the first hour of trading.

While it is difficult to determine how many investors have left the options market as a result of higher prices, recent volumes do suggest that some players have left. In the two-week period ending Oct. 3, which coincided with the Securities and Exchange Commission’s ban on short selling, the average daily volume reached 14.2 million, below the daily average for 2008 of 14.7 million.

The options market has enjoyed a surge of activity this week. That is to be expected as the stock market has plummeted in what experts are calling a “slow-motion crash.”

The market also appears to be enjoying a pick-up in activity Friday, with roughly 13.1 million contracts changing hands as of 12:30 p.m. EDT. That puts the market on pace to close above $25 million – a historically high number.

Even so, experts said the prices are keeping many players at bay. Options costs are “pricing some people out of the market because it’s just too expensive to hedge,” said Michael Schwartz, chief options strategist with Oppenheimer & Co.

While options might be prohibitively expensive to use as a hedge, experts like Mr. Schwartz say some investors might be able to use those high prices to their advantage. If investors are tempted by cheap prices in the stock market and have started to consider buying, for example, they could purchase stock and sell puts to offset the cost.

If investors wanted to buy shares in General Electric Co., for example, they could buy the stock at its current price of $19.13 and sell January $17.50 puts, which are going for $2.80. By selling the puts, the investors has, in effect, bought the shares for $16.33.

If the puts are exercised, the investor has to be willing to buy additional shares in GE for $17.50. If the puts are not exercised, the investor at least got the stock at a $2.80 discount. “With regard to strategies you can implement in this environment, you have to be a seller rather than a buyer,” Mr. Schwartz said.

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