How to trade the silver VOLATILITY using options

[swissaustrian]

The following is a copy of a post, I originally made after the big silver crash back in may 2011 at Ron Paul Forums: http://www.ronpaulforums.com/showthread.php?292691-How-to-trade-the-commodities-VOLATILITY

I think it´s offering a useful strategy for traders. I made some minor adjustments to the original post.

Note: The following text should not be interpreted as a professional investment advice. Make you own decisions and be sure to fully understand every product you buy.

We see huge volatility in commodities right now.
My opinion is that this is gonna continue for a while.

I trade options regularly and i want to share an investment idea with you. Here is how you trade when you know there are going to be major movements in prices, but you can´t really figure out in which direction they are going to be. In other words: you trade the volatility. Your expectation is that prices won´t stay at the same levels.

Luckily www.optionsguide.com offers a good description of the trade, so I don´t need to write everything down on my own. The trade is called long guts:

From http://www.theoptionsguide.com/long-guts.aspx:

The long guts is a neutral strategy in options trading that involve the simultaneous buying of an in-the-money call option and an in-the-money put option of the same underlying stock and expiration date.

Long Guts Construction
Buy 1 ITM Call
Buy 1 ITM Put

This is an unlimited profit, limited risk strategy that is taken when the options trader thinks that the underlying stock will experience significant volatility in the near term. The long guts is a debit spread as a net debit is taken to enter the trade.

Unlimited Profit Potential
Large gains for the long guts strategy is attained when the underlying stock price makes a very strong move either upwards or downwards at expiration. The move in the underlying stock price must be strong enough such that either the long call or the long put rise enough in value to offset the loss incurred by the other option expiring worthless.

The formula for calculating profit is given below:

•Maximum Profit = Unlimited
•Profit Achieved When Price of Underlying < Strike Price of Long Put - Net Premium Paid OR Price of Underlying > Long Call + Net Premium Paid
•Profit = Price of Underlying - Strike Price of Long Call - Net Premium Paid OR Strike Price of Long Put - Price of Underlying - Premium Paid

Limited Risk
Maximum loss for the long guts strategy occurs when the underlying stock price on expiration date is trading between the strike prices of the options bought. At this price, while both options expire in the money, they have lost all their time value. It is this loss in time value that is the cost of employing the long guts strategy.

The formula for calculating maximum loss is given below:

•Max Loss = Net Premium Paid + Strike Price of Long Put - Strike Price of Long Call + Commissions Paid
•Max Loss Occurs When Price of Underlying is in between the Strike Prices of the Long Call and the Long Put

I would suggest to buy silver-options because this market is the most volatile one.
If you are generally bullish but you want to hedge to the downside, you should basicly do the the same as above but with a 2:1 call/put-ratio. This is called "strap" ( http://www.theoptionsguide.com/strap.aspx)

 

[swissaustrian]

bumping this thread. Still a good trade at the current levels.
I´m already net positive.

 

[swissaustrian]

Closed 50% of my short position with a 114% gain.
Waiting to see the trend manifest itself to sell the other 50%.

 

[swissaustrian]

Just sold the other 50% of my shorts at 26.88 with a modest gain of 69%.
Regardless what happens to my long position, I already realized 162% on my long/short investment, meaning I made a whopping 62% in just 2 weeks on this trade. This could get even better if silver gets above ~ 30 before april.

 

[DCFusor]

I need to learn more about this myself - At present I don't use options in trading.
I think I need to find some software that looks at the current option prices and builds those charts off them - with real numbers, so I can better assess risk/reward at the current pricing of options at various ITM/OTM points.

 

[swissaustrian]

I need to learn more about this myself - At present I don't use options in trading.
I think I need to find some software that looks at the current option prices and builds those charts off them - with real numbers, so I can better assess risk/reward at the current pricing of options at various ITM/OTM points.

A few things I can give as advice:
1. Doing the math correctly is essential. I use a trading plattform that my former employee (a futures fund) also used. It´s very expensive, but a great tool: http://expersoft.ch/expersoft-pm1e-suite.html
I think to start with you can use a free options calculator like this web based one: https://www.cboe.com/LearnCenter/OptionCalculator.aspx
I would do some testing without investing real money first.
2. I don´t use exchange traded (COMEX) options. I customize my own options directly with my bank (a tbtf bank). These options are called over the counter options. There are banks in the US which offer these services, too. Definitely the tbtf like goldman or jpm.
3. The volatility trade cited above needs some patience. I wouldn´t buy short term options. 6 months duration is a reasonable timeframe from my experience.
4. Flexibility is key. Be sure you can close your positions at any time.
5. If you want to read a book on options first, I recommand this one:
[ame="http://www.amazon.com/Options-Futures-Derivatives-DerivaGem-Package/dp/0132777428/ref=sr_1_1?ie=UTF8&qid=1325688171&sr=8-1"]Amazon.com: Options, Futures, and Other Derivatives and DerivaGem CD Package (8th Edition) (9780132777421): John C. Hull: Books@@AMEPARAM@@http://ecx.images-amazon.com/images/I/516p8PYPkbL.@@AMEPARAM@@516p8PYPkbL[/ame]
I know it´s pretty expensive

 

[DCFusor]

Thanks, SA! As a computer guy and scientist, expensive books are not a shock to me (I even wrote one). In this case, the "right stuff" is much more important - all the junk books I got cheap at the used bookstore are lame, and bad info could lose me real money, after all...

I'll check out the other stuff too. I've been hankering to use the API over at TDAmeritrade where I trade, which I've got a copy of and support to just write my own doggone platform that does what *I* want, but it's been a question of supporting my other business first, of late. Sigh, hours in the day and all that.

 

[swissaustrian]

Thanks, SA! As a computer guy and scientist, expensive books are not a shock to me (I even wrote one). In this case, the "right stuff" is much more important - all the junk books I got cheap at the used bookstore are lame, and bad info could lose me real money, after all...

I'll check out the other stuff too. I've been hankering to use the API over at TDAmeritrade where I trade, which I've got a copy of and support to just write my own doggone platform that does what *I* want, but it's been a question of supporting my other business first, of late. Sigh, hours in the day and all that.

Your professional background will definitely help you learning options quickly. The math will probably be a cakewalk for you anyway.

 

[swissaustrian]

Casey Research posted an interesting article on gold and silver volatility a few days ago:
http://www.caseyresearch.com/articles/face-volatility?ppref=ZHB442ED0312A

By Jeff Clark, Casey Research
On February 29, gold dropped 4.8% and silver 6.2% (based on London fix prices). That's quite the fall for one day. We've seen prices that have risen that much, too. But as I'm about to show, these ain't nothin', baby.
Based on our experience, we've been saying for some time that volatility will increase as the markets fight their way to the mania phase of this cycle – and that once there, the gyrations will jump even higher. This call doesn't exactly require one to go out on a limb; it makes sense since more investors will be crowding in – and volatility was high in the 1979-'80 mania.
First, let's put last Wednesday's big plunge in perspective. Here's a picture of the daily changes in the gold price since 2003, based on London fix prices. (This chart is very busy, but I want to show the bulk of the bull market in one visual.)

A 4.8% decline is one of gold's bigger one-day movements over the past nine-plus years. But as you can see, there have been a number of days where gold rose or fell more than 5%. And it exceeded 6% on five occasions.
Here are the data for silver.

Last Wednesday's decline of 6.2% was one of the metal's bigger one-day movements. However, it's exceeded 10% on 14 occasions, 15% three times, and rose an incredible 20.06% on September 18, 2008.
You might think this kind of volatility is high – and it's true. Worse – or better, depending on how you see things – the volatility in the underlying commodity is magnified in the related company stocks. This is why Doug Casey calls mining stocks, especially the juniors, "the most volatile stocks on earth." But the thing is, metals volatility has been higher in the past, particularly during a mania.
Here's what I mean.
The following chart documents gold's daily price changes from 1976 through the end of 1980. Take a look at the jump in volatility in 1979-'80.

Volatility became the norm in 1979 and especially 1980. Fluctuations of 4% or more were not uncommon.
Here's the same chart for silver. The metal's volatility during the 1979-'80 period became extreme.

Daily price movements of 6% or more didn't occur once prior to 1979 – but then they became commonplace.
...
Continue reading here: http://www.caseyresearch.com/articles/face-volatility?ppref=ZHB442ED0312A

 

[ancona]

SA,
When government began the practice of gold leasing and silver and gold were paperized, volatility became the norm because it was now possible to sell unbackerd shares of a commodity that my or may not even be in the posession of the seller. Like SLV and GLD, fractional reserve gold and silver sales are 99 percent of today's market, so if there is sudden demand for the real thing, the sellers of fantasy gold and silver panic.

 

[swissaustrian]

OK. I'll probably open up another volatility trade for silver tomorrow.

 

[KMS]

Bump. Great thread, also had to search for it. Subscribed.

You da man SA.

 

[swissaustrian]

The current raid offers another entry point for a silver volatility trade. I'm not sure whether we go up or down in the near future but I'm sure we aren't going to stay where we are (31.5) for a long time, so I'm going long and short.

 

[ancona]

With our government in a completely untenable position, forced to extend the debt ceiling and go even deeper in to teh giant black hole of national debt, silver and gold can only be held back for so long. Eventually, that rubber band will snap back, and when it does it will be biblical.

 

[bushi]

Hi guys,

Following the series here, I have a feeling that Research in Motion (Blackberry maker), is a potential candidate for that option trade, that exploits volatility.

Why I think so - they are about to release their "make it or breake it" version of OS and phoners - Blackberry X, at Jan 27th (AFAIR). This is "all or nothing" effort for the company. The buzz is high in tech circles, some of the people are enthusiastic (I think the user experience looks great, fantastic for power users, but... the problem is, it is not Android nor iOS ), therefore some other ppl are skeptical...

Either way, there is potential to a significant change in unknown direction, depending how the thing unveils after the launch. Some of you traders might want to look at this closer.

cheers.

 

[swissaustrian]

Sorry bushi for not responding earlier, but you were right RIMM would have been a great volatility trade and probably still is:
http://www.zerohedge.com/news/2013-01-30/rimmberrr-10

 

[bushi]

no worries. I was watching live stream of the event, and now I am pretty certain, that RIM (or rather, Blackberry, as they are known from now on), has no chance of survival.

Like I said, fantastic interface for power users (and power users only), some really nifty tricks with screen sharing while on the chat, having two separate "workspaces" in one phone (one for work, managed by your IT department, the other for your personal stuff - so for example, IT dept can wipe out your "work" partition remotely, when you leave the company or lost the phone, but your personal stuff is not touched ny that - niiice!), etc.. But all in all, I think it feels way too much like playing a catch-up, with some nifty unique features, but that's just that..

Oh, and that CEO of theirs, on the stage - my gosh, it was embarrassing to watch, he is such a fucking disastrous presenter, fuck me... Dead, rotting jellyfish have more spine & XFactor, than he has... Words cannot describe, how hopeless and flat that presentation was delivered. It only changed to better each time, when somebody else was taking over the stage - project managers, developer relations managers, etc. If he couldn't figure out, that he should NEVER, EVER have been presenting that event - how on earth is he supposed to make strategic decisions for the whole fecking company?

I feel sorry for the Canadian fellow tech guys hired by BB, but I am pretty sure they are going down, despite having quite interesting product(s) on their hands.

 

[swissaustrian]

For the paper traders here at pmbug:
If you wanna make a hedged bet on the massive silver rally ahead, you can open a spread trade with a long bias. Buy July calls and July puts with a 2:1 call/put ratio, as described in the op of this thread.

Possible Strikes:
Call 28.5 or 29.
Put 26 or 25.

Such a trade is called a strap:

Note: Make sure you do the math yourselves and be aware of the risks involved in options trading.

 

[swissaustrian]

h/t to ZH for the following chart:

The current crash in gold was out of the value at risk (VaR) range for many models. The percentage change is so far away from regular price drops that it presents a black swan.

 

[pmbug]

Like I have said before, it smells like 2008.

 

[benjamen]

h/t to ZH for the following chart:

The current crash in gold was out of the value at risk (VaR) range for many models. The percentage change is so far away from regular price drops that it presents a black swan.

Wow, for those that are not familar with VaR, most finance people cover themselves for 2 or 3 standard deviations of risk and think they are good. A really conservative company might guard against 5 standard deviations at most.

Something being within 3 Standard deviations means you are covered 369 out of 370 events (99.73%).

For something to be outside 7 Standard deviations, you are talking about an event of 1 in 390,682,215,445!

Reference:
http://en.wikipedia.org/wiki/68-95-99.7_rule
http://en.wikipedia.org/wiki/Standard_deviation

 

[swissaustrian]

Yes, 1 in 390,682,215,445 .
Can you imagine? How many parallel universes did experience a similar drop? Not many. We're witnessing something very special here.
The 7 st.dev. move is a nightmare for options sellers by the way. They can't precisely calculate the risk (volatility) premium. Options prices have skyrocketed due to that. That's great news for the banks, ie the sellers. At least as long as we don't get another move like this, especially to the upside.

 

[swissaustrian]

A second note to VaR, options, and gold:
LTCM collapsed in 1998 due to volatility that was outside their expected range. They operated using VaR.
There rumors out there that LTCM was heavily short gold (400 tons) and that this was the true reason for the bailout. The FED had to prevent a disorderly spike in gold.
http://www.financialsensearchive.com/fsu/editorials/kirby/2007/0709.html

Interestingly, Jim Rickards was the General Counsel for LTCM during the liquidation. He denied the gold rumors:

James G. Rickards, who sent us a letter, along with an affidavit from fund principal Eric Rosenfeld. Rickards stated that Long- Term Capital Management denied any involvement in the manipulation of the gold market, and Rosenfeld said to the Cafe, "None of LTCM, LTCP, nor their affiliates, has ever entered into any transaction involving the purchase or sale of gold, including without limitation, spot, forwards, options, futures, loans, borrowings, repurchases, coin or bullion, long or short, physical or derivative, or in any other form whatsoever."

http://www.gold-eagle.com/gold_digest_99/murphy090899.html

However, I take anything that a guy with such intimate connections to the intelligence community (Iran hostage negotiator, Pentagon wargames) with a grain of salt.

 

[swissaustrian]

Even Dennis Gartman gets it:

Dennis Gartman of The Gartman Letter, writes today:

"Concerning gold, let's note firstly something sent to us by our old friend John Brimelow, who had a most interesting piece in his commentary this morning regarding the violence of the recent price changes. He noted a piece written by Russell Rhoads, CFA of the CBOE Option Institute, who wrote the following:

"'Friday was a 4.88 standard deviation move in the price of gold. For simplicity's sake let's call it a five standard deviation move. Statistically we get a five standard deviation move approximately once every 4,776 years. So we should not expect another move like this out of the price of gold until May 17, 6789. ... Currently the two-day price change in GLD is 16.65, which can be converted to just over eight standard deviations. I wanted to share what this comes to, but the table I use only goes up to seven standard deviations. Let's just say the sun is expected to burn out first.'"
Gartman continues: "We shall confidently say that we will never, ever see a day such as we saw yesterday in the gold market in our lifetime again. It will not happen. The sun will indeed burn out before we see anything such as that again. Nor shall we ever want to see anything such as that again. We can reasonably deal with deviations from the norm of 2 or 3 or perhaps even 4, but 8+ standard deviations is beyond our ken or that of anyone else anywhere. Yesterday's price action will go down in history as an aberration of truly historic proportions.

"We judge the violence of the market's movements by the numbers of requests for interviews made of us, for the correlation between high numbers of such requests is nearly 1:1 with peaks and valleys of various markets. A large number of requests made of us is four or five a day; a truly large number is eight. Yesterday we had 12, and we've agreed to give several more today that we could not fit into our schedule yesterday. This befits an 8+ standard deviation day."

Ah, yes, "an aberration of truly historic proportions" -- but while central banks are the biggest gold traders, that aberration was still not large enough to prompt Gartman to put a question to a central bank or two. Yes, in that respect as well the sun will burn out first.

http://gata.org/node/12460

 

[pmbug]

He's willing to sensationalize, but not to dig too deep for answers.

 

[bushi]

well, "we will never see a move like that" - "never", is a very long time...

I am by no means an expert, but VaR models are being questioned, in case of "black swans", by people much smarter than meself (James Rickards is one of them). In other words - use them when the sea is smooth, but do not expect them to work or give good guidance, in times of troubles - because static analysis doesn't really apply to the markets in every case - only in very specific cases (only where there is relatively low volatility).

He proposes that markets should be rather seen as dynamic systems, in which chain reactions are possible and quite expected, when times are rough- what makes some initial criteria met for a number of "actors" - they react, and they reaction changes the price, so it triggers reaction of other actors now (usually, in greater numbers than the first wave), etc...

Just you wait, if price rebounds strongly - how many people would think "this is it, the bottom is in", and jump on board immediately, pushing prices up nearly or as fast, as they went down? Will GATA report that "it shouldn't had happened"

 

[pmbug]

Does 7-9 standard deviations qualify as "blood in the streets"?

 

[swissaustrian]

Does 7-9 standard deviations qualify as "blood in the streets"?

More like nuclear armageddon. As benjamen said, there is a 1 in 390,682,215,445 chance for such an event Winning the jackpot in a lottery is more likely than that.

 

[swissaustrian]

well, "we will never see a move like that" - "never", is a very long time...

I am by no means an expert, but VaR models are being questioned, in case of "black swans", by people much smarter than meself (James Rickards is one of them). In other words - use them when the sea is smooth, but do not expect them to work or give good guidance, in times of troubles - because static analysis doesn't really apply to the markets in every case - only in very specific cases (only where there is relatively low volatility).

He proposes that markets should be rather seen as dynamic systems, in which chain reactions are possible and quite expected, when times are rough- what makes some initial criteria met for a number of "actors" - they react, and they reaction changes the price, so it triggers reaction of other actors now (usually, in greater numbers than the first wave), etc...

Just you wait, if price rebounds strongly - how many people would think "this is it, the bottom is in", and jump on board immediately, pushing prices up nearly or as fast, as they went down? Will GATA report that "it shouldn't had happened"

Yes VaR is flawed. But the whole financial system is built on it. Especially the derivatives market. Imagine we would get a bond crash and all the outstanding interest rates swaps would blow up. That's one giant black hole :flail:

 

[benjamen]

well, "we will never see a move like that" - "never", is a very long time...

I am by no means an expert, but VaR models are being questioned, in case of "black swans", by people much smarter than meself (James Rickards is one of them). In other words - use them when the sea is smooth, but do not expect them to work or give good guidance, in times of troubles - because static analysis doesn't really apply to the markets in every case - only in very specific cases (only where there is relatively low volatility).

He proposes that markets should be rather seen as dynamic systems, in which chain reactions are possible and quite expected, when times are rough- what makes some initial criteria met for a number of "actors" - they react, and they reaction changes the price, so it triggers reaction of other actors now (usually, in greater numbers than the first wave), etc...

Just you wait, if price rebounds strongly - how many people would think "this is it, the bottom is in", and jump on board immediately, pushing prices up nearly or as fast, as they went down? Will GATA report that "it shouldn't had happened"

Essentially, it is a statistics issue. The VaR model is based on the normal distribution, but in real life the correct model would have "fatter tails" than a true normal distribution. Essentially, the VaR model doesn't handle extreme (3+ standard deviation) events very well.

Reference:
http://www.fattails.ca/
http://en.wikipedia.org/wiki/Fat_tail
http://www.highbeam.com/doc/1G1-126933620.html

 

[swissaustrian]

Benoit Mandelbrot and Nassim Taleb have written extensively about the falsehood of Gaußian (normal) distribution in financial markets. They're are using fractal distribution instead.

[ame="http://www.amazon.com/The-Misbehavior-Markets-Financial-Turbulence/dp/B002PJ4GGI"]The Misbehavior of Markets: A Fractal View of Financial Turbulence: Benoit Mandelbrot, Richard L. Hudson: Amazon.com: Books@@AMEPARAM@@http://ecx.images-amazon.com/images/I/51FRT5192HL.@@AMEPARAM@@51FRT5192HL[/ame]

 

[bushi]

Yes VaR is flawed. But the whole financial system is built on it. Especially the derivatives market. Imagine we would get a bond crash and all the outstanding interest rates swaps would blow up. That's one giant black hole :flail:

That's why I've skipped the whole "educate yourself about financial markets" part, and went straight into PMs/hard assets - I think we are going to see the end of it in our lifetimes (soon, I'd say). The risks are enormous and keep pilling on, and I prefer to "Keep it simple, stupid"

It is interesting and refereshing, to talk about all that stuff with someone intelligent, but not biased, invested, interested, nor "educated" on the topic - people tend to grasp immediately, that the whole big picture is terribly wrong. But not when you are "established economist", nonono.... My wife is a prime example. She had a very tough childhood, so she is not terribly well educated in formal sense, but she is very intelligent, practical to the core, and seriously "no bullshit" kind of person. She usually keeps away from these "world issues", and keeps day-to-day practical. But occasionally, we speak about these things (it is OUR money, after all, so I don't make any serious decisions without consulting her), and I am always amused at her reactions. She is like "it is obvious, it cannot work long term", or "but it is clearly a fraud", or things like that. She shrugs her shoulders, and keeps carrying on . Makes MY life simpler

I suspect, most people only learn to think for themselves, when their life circumstances force them to do so. Otherwise, they tend to stop without thinking "what CAN possibly go wrong in that case, and what will happen if it DOES go wrong"

Again, statistical distributions, of all kinds, are also STATIC, they don't take into account the dynamics of the system. We can only crunch some (most recent) snapshot numbers, at any given time, and arrive at some conclusions.

But the whole system is not static, and it is full of feedback loops. Sometimes positive, sometimes negative, and sometimes - runaway feedback loops. I think that for most of the time, statistics CAN do a good job, but not when the whole system is in the "rough seas" mode. But what poor financial guys have to show other than these models - so they keep using them, and pray for all to go well...

 

[swissaustrian]

WTI oil has been crashing relentlessly during the last few months. It's primed for a volatility trade. The 50 dma is at 77, 200 dma at 94, current price at 58.
http://stockcharts.com/h-sc/ui?s=%24WTIC
These are massive gaps. They usually close. Momentum is very oversold. Does it mean it will revert immediately? Is the crash over? I have no idea. I am 99.9% sure that it is going to be very volatily though, so I started another volatility trade with options, description of the design of such a trade is in the op of this thread.

 

[swissaustrian]

I have closed my puts today, oil so oversold and we will get some bigger rebound soon I think. I am keeping the calls and see if a rebound goes above 60.5 which would be the profit barrier for my calls. The net trade will be positive no matter what happens from here on, because I made a killing on the puts.