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May 2012 | Vol. 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
Are Bonds Telling the
VIX Next Move?
An Interview with
Mark Sebastian
Managing the Short Time Spread
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ONTHLYT H E O P T I O N T R A D E R S J O U R N A L
editorial
Bill LubJred Woodrd
Mrk Sebstin
andrew Giovinzzi
design/layout
Luren Woodrow
contact information
Editoril comments: editor@expiringmonthl.com
advertising nd Sles
Expiring Monthl PresidentMrk Sebstin: mrks@expiringmonthl.com
Phone: 773.661.6620
The informtion presented in this publiction does not consider our
personl investment objectives or nncil sitution; therefore, this
publiction does not mke personlized recommendtions. This infor-
mtion should not be construed s n oer to sell or solicittion to
bu n securit. The investment strtegies or the securities m not
be suitble for ou. We believe the informtion provided is relible;
however, Expiring Monthl nd its lited personnel do not gur-
ntee its ccurc, timeliness, or completeness. an nd ll opinionsexpressed in this publiction re subject to chnge without notice. In
respect to the compnies or securities covered in these mterils, the
respective person, nlst, or writer certies to Expiring Monthl tht
the views expressed ccurtel reect his or her own personl views
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mendtions (if mde) or views contined in this publiction. Expiring
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loss in trding securities, options, futures, nd forex cn be substntil.
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ment Chrcteristics nd Risks of Stndrdized Options. a cop cn
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chrcter-risks.jsp.
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is prohibited nd subject to libilit. Copright 2012, Expiring Monthl.
contents
4 e n
Bill Luby
5 a x
The Expiring Monthly Editors
7 m s t s
Andrew Giovinazzi
8 a B t Vix n mv?
Mark Sebastian
10 r u: e V
p (p 2)
Jared Woodard
11 expiring monthly feature
t e V m
Bill Luby
16 e m iv
Mark Sebastian
Jared Woodard
19 floorstories: h lq pv
p o
Andrew Giovinazzi
21 followthattrade: g a
n g
Jared Woodard
23 backpage: t e B
Mark Sebastian
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About the
Expiring Monthly Team
Bill Luby
Bill is privte investor whose reserch
nd trding interests focus on voltilit,
mrket sentiment, technicl nlsis,
nd ETFs. His work hs been hs been
quoted in the Wll Street Journl,
Finncil Times, Brrons nd other
publictions. a contributor to Brrons
nd Minnville, Bill lso uthors the VIX
nd More blog nd n investment
newsletter from just north of Sn
Frncisco. He hs been trding options since 1998.
Prior to becoming full-time investor, Bill ws business strt-
eg consultnt for two decdes nd dvised clients cross
brod rnge of industries on issues such s strteg formul-
tion, strteg implementtion, nd metrics. When not trding or
blogging, he cn often be found running, hiking, nd kking
in Northern Cliforni.
Bill hs Ba from Stnford Universit nd n MBa from
Crnegie-Mellon Universit.
Jared Woodard Jred is the principl of CondorOptions. With over decde of
experience trding options, equities,
nd futures, he publishes the Condor
Options newsletter (iron condors) nd
ssocited blog.
Jred hs been quoted in vrious
medi outlets including The Wll
Street Journl, Bloomberg, Finncil
Times alphville, nd The Chicgo Sun-Times. He is lso con-
tributor to TheStreets Options Prots service.
In 2008, he ws proled s top options mentor in Stocks,
Futures, nd Options Mgzine. He is lso n ssocite member
of the Ntionl Futures assocition nd registered principl of
Clinmen Finncil Group LLC, commodit trding dvisor.
Jred hs msters degrees from Fordhm Universit nd the
Universit of Edinburgh.
Mark Sebastian
Mrk is professionl option trder
nd option mentor. He grduted
from Villnov Universit in 2001 with
degree in nnce. He ws hired into
n option trder trining progrm b
Group 1 Trding. He spent two ers
in New york trding options on the
americn Stock Exchnge before
moving bck to Chicgo to trde SPX
nd DJX options For the next ve
ers, he trded vriet of option products successfull, both
on nd o the CBOE oor.
In December 2008 he strted working s mentor t Sheridn
Option Mentoring. Currentl, Mrk writes dil blog on ll
things option trding t Option911.com nd works prt time
s risk mnger for hedge fund. In Mrch 2010 he becme
Director of Eduction for new eduction rm OptionPit.com.
AndrewGiovinazzi andrew Giovinzzi strted his creer in
the nncil mrkets fter grduting
from the Universit of Cliforni, Snt
Cruz with B.a. in Economics in 1989.
He joined Group One, Ltd. nd quickl
becme member of the Pcic Stock
Exchnge (nd lter the CBOE), where
he trded both equit nd index
options over 15 er spn. During
tht period he never hd down er.
at the sme time, andrew strted nd rn the Designted
Primr Mrket Mrker post for GroupOne on the oor of the
CBOE. It becme one of the highest-grossing posts for the
compn in 1992 nd 1993. While ctivel trding, andrew ws
instrumentl in creting nd mnging n option trder trin-
ing progrm for Group One.
He left Group One, Ltd. to co-found Henr Cpitl Mngement
in 2001. andrew then joined aqumin LLC (20082011) to help
bring 3D quoting nd nlsis to nncil dt. He is Chief
Options Strtegist t Option Pit.
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Editors
NotesBill Luby
The M options expirtion ccle sw stretch in which the
VIX rose in eleven out of thirteen ds, s the mrkets fret-
ted over the outcome of the next election in Greece nd the
implictions for the euro zone nd cross the globe. While
the voltilit indices hve risen, there seems to be big
disconnect between the mrkets current expecttions for
future voltilit nd some of the dire predictions bout the
future of the euro zone. The M edition ofExpiring Monthly
ttempts to ddress some of the issues relted the current
sitution from number of perspectives.
andrew Giovinzzi exmines short time spreds such s
the recent London Whle trde t JP Morgn, where losses
re now likel to top $7 billion. andrew focuses on how to
understnd nd mnge the risks inherent in these short
time spreds. In seprte rticle, andrew exmines the
evolution of how liquidit providers hve priced options, with
n emphsis on how trding implied voltilit hs come to
dominte current thinking.
Mrk Sebstin hs thought-provoking piece which
looks t the spred between TLT (the 20+ yer Tresur
Bond ETF) nd the VIX. This rticle hs some interest-
ing implictions for risk mngement s well s trding
strtegies.
In Risk or Uncertint: Explining the Vrince Risk
Premium (Prt 2), Jred Woodrd extends his nlsis of
ambiguit aversion nd Vrince Premium, recent pper
b Jinjun Mio, Bin Wei, nd Ho Zhou tht oers n mbi-
guit-bsed explntion for vrince premium.
Jred lso hs chnce to turn the tbles little, mking
Mrk Sebstin the subject of this months feture interview
Jred tlks with Mrk bout wide rnge of topics from con-
sulting to hedge funds on risk mngement to order ow to
mentoring options trders.
I m responsible for this months feture rticle: The
Expnding Voltilit Megplex. In this rticle I trce the evo-
lution of voltilit indices nd nlze where the re going
s well s some of the criticl success fctors.
Jred Woodrd tkes the Follow Tht Trde segment in
n intriguing direction, running with Je Gundlch notion
of men reversion pirs trde tht pits apple ginst
nturl gs.
Once gin, the EM tem is bck to nswer reder ques-
tions in the ask the Xperts segment. Lst but not lest, Mrk
Sebstin mns the Bck Pge, where he opines bout big
losing trdes, relistic expecttions nd the lure of some
get-rich-quick options trding schemes.
as lws, reders re encourged to send questions,
comments or guest rticle contribution ides to editor@
expiringmonthl.com.
Hve good expirtion ccle,
Bill Lub
Contributing Editor
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Q: I am just starting to do
some international busi-
ness, and a customer
needs to pay me in euros.
This is for a large transac-
tion, and I know that I will
receive a specic number
of euros in about a month.
Normally, I wouldnt care,
but given everything going
on in Greece, I think I
should hedge that currency
exposure, since I do every-
thing else in U.S. dollars. I
thought about buying puts
on FXE, but with implied
volatility being where it is,
I wonder if there is a better
approach here?
James D.
A: Ive ctull received
this question from few
people over the lst severl
weeks, nd its n impor-
tnt thing to be wre of if
ou do business in multiple
countries.
Remember tht n time
ou bu n option, oure
lws ping more thn
the intrinsic vlue of the
underling sset. Since
oure not tring to express
prticulr view bout
voltilit here, this is
sitution where I would sug-
gest using the underling
insted of using options,
either vi the 6E futures or
the FXE ETF.
Right now, one euro is
worth bout 1.27 U.S.
dollrs. If oure going to
receive xed mount of
euros in the future nd ou
wnt to lock in the current
exchnge rte vs. dollrs,
ou could sell short thefutures in the pproprite
size: one contrct t the
CME equls 125,000 euros,
or there is mini contrct
sized t 62,500 EUR. If
our trnsction is smller
thn tht, ou cn use the
FXE ETF.
as side note, in ll the
brethless commentr in
the nncil medi bout
the derivtives losses of J.P.
Morgn nd other bnks
nd funds, its es to for-
get tht futures nd options
hve been round since
ncient times, nd serve
ver vluble economic
function when properl
regulted.
Jred
Q: I am writing to you
because if you attempt
to download daily closing
VIX data from the CBOE
you get two dierent data
series! You get one if you
download it from here
(http://www.cboe.com/
publish/ScheduledTsk/
MktDt/dthouse/vix-
rchive.xls and http://
www.cboe.com/publish/
ScheduledTsk/MktDt/
dthouse/vixcurrent.csv)
and another dierent one ifyou download it from here
(http://www.cboe.com/
micro/buwrite/dilprice-
histor.xls)!
All told there are 45 data
points that are dierent.
Could you tell me which
data series is the right one?
Alberto
A: Prt of the reson there
re multiple sets of dt
is tht the methodolog
used to clculte the VIX
ws chnged in September
2003. Dt set #1 below
included dt tht ws
historicll reconstructed
for the new VIX clcul-
tion methodolog tht
went into eect in 2003
nd includes ll VIX dt
from 19902003. Dt set
#2 picks up with the new
VIX from 2004 to the pres-
ent with ctul rel-time
mrket dt for which there
ws no need to historicll
reconstruct nthing.
The strnger in the group is
dt set #3. This includes
VIX dt (closing prices
onl) tht is subset of the
VIX dt in dt set #1 nd
dt set #2. It lso includes
dt for eight other indi-
ces. One of these eight is
the originl VIX (ticker
VXO) dt tht ws used
to clculte the VIX from
its lunch in 1993 to the
chnge in clcultion meth-
odolog in 2003.
[This post on the Histor
of the VIX nd VXO might
help with some bckground
informtion.]
These re three dt
sets ou referenced:
1. VIX: 19902003
2. VIX: 2004present
3. Nine tickers, including
VIX nd: 19862011
For our circumstnces,
m suggestion would be
to ppend dt set #2 todt set #1 to get the most
complete record of VIX his-
toricl dt. Going forwrd,
the onl dt set ou need
to concern ourself for
future dt points is #2.
Bill
Ask the
pertsThe Expiring Monthly Editors
http://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://vixandmore.blogspot.com/2008/10/vxo-chart-from-1987-1988-and.htmlhttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/micro/buywrite/dailypricehistory.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixcurrent.csvhttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xlshttp://www.cboe.com/publish/ScheduledTask/MktData/datahouse/vixarchive.xls -
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Ask the Xperts (continued)
Q: What is the best set-up
for a trading oce?
Jon
A: While ever trder is
dierent, I would personll
set up the following things:
super fst computer
nd internet line. If one
wnts to rell be pro,
get business clss cble
nd spend lot of mone
on fst CPU. In the long
run, it will sve ou lot
of mone. Get comfort-
ble chir, ou will be in it
lot, so dont skimp here.
Do not get desk with
lot of drwers, this is not
our home oce, this is
trding spcethe re
ou trde in should hve
little to no non-trding
things round it. Get sev-
erl screens, one for ever
piece of trding softwre
ou use, nd then t lest
one extr for the miscel-
lneous work one might
do like surng the web
for informtion, or tping.
Finll, get TV, but do not
wtch the nncil news
networks during trding
hours; I dont cre if its the
Price is Right or ESPN, but
do not hve the nncil
networks running, the will
serve to ll our hed with
bd ides. Finll, think
bout hving smll weight
ling round the oce,
even if its onl 23 pounds.
When ou re thinking,
bored, or bsicll n-
thing, grb the weight nd
do rm curls or triceps curls
. . . our mte will thnk
ou lter becuse our
rms will look wesome
surprisingl quickl. Notice,
no fridge, no keggertor,
no snck shop. If ou must
hve beverge mchinein the oce mke it cof-
fee mker.
Mrk
http://www.condoroptions.com/ -
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Managing the
Short Time SpreadAndrew Giovinazzi
themarketsgot doublewhmm in the middle of M. First,
the debt reduction greement for
Greece ws promptl thrown out the
window when the Greeks could not
form government to bide b the
greement lred in plce. actull,
I thought to mself, Does tht men
the owe the bond holders the full
mount gin? Second, JP Morgn lost
some mone on trde, big trde.
The events together drove the SPX
down round 60 hndles nd the VIX
up to 25 on the close Frid the 18th.
It looks like no rll into the summer
nd ros equit mrket prior to the
elections. Wht looks likel is tht the
Greek voters will hve new elections
fter June Expirtion nd JP Morgn
will hve to swet out their big posi-
tions until mid-December where the
will hve to trde the roll of the cen-
tur. Tht brings me to the trde ques-
tion for this column. Is the short time
spred right for wht is going on in the
mcro world?
Lets tke some of the coverge on
JPM. It ws reported in The Wall Street
Journal tht JPM hd vrition of
short time spred on. Essentill the
bnk is long erlier-dted CDS index
contrcts in December 2012 nd short
frther-dted contrcts in 2015. For
our column here the exct trdes re
not tht importnt (not m p/l fter ll)
but it is the structure of the trdes tht
re importnt.
Measuring Short Time Spread
Risk
The short time spred is just long
contrct in the front month nd short
contrct in the bck month. The thing
most retil trders will notice is tht
it tkes up lots of buing power. So
much so, tht the front month contrct
is lmost ignored in the BP clcul-
tion when trders hve to go mrgin
the position. Tht is the problem, if
the reported news bout JPM is to be
believed. The mrk-to-mrket cn
get ugl. Risk-wise, here is wht trd-
ers fce:
t
v. Implied voltilit cn go
up for ver long time before
it comes in gin. This directl
ects the veg component of the
trde. Generll speking the lon-
ger the term, the greter the risk
involved. JPM looks to hve con-
trcts out quite ws so the dil
mrks re ugl. But just s esil is
the risk premiums melt in the secu-rities due to reduced perception
in risk, ll the mone comes bck.
Weighted veg is the other
snek component here. The totl
risk veg shows up ne but s
the terms distnce expnds both
vegs cn move in opposite direc-
tions. This is the equivlent of hv-
ing the trders hed in vise like
in Casino nd hoping Joe Pesci will
hve some merc.
t . as the underling secu-
rit for the trde whips round nd
moves, the short time spred ctu-
ll strts to perform. The frther
the underling goes from the initil
entr point the better. Short time
spreds re perfect for underling
movement tht is about to hap-
pen in high voltilit environ-
ment. The trde is generll bd
t for movement tht hs lred
hppened.
t
. The dil chew from thet
erosion mkes underling move-
ment big prt of this position.
If the underling does not move
nd ll is still, or keeps to tight
rnge, the thet could swllow up
the dollrs from the bck month IV
implosion.
t
fat contracts. Risk mngers like
this prt becuse the trde cn-
not blow up on size underling
move. This is lso the reson the
trde cn slip under the risk rdr.
Is the short timespred right forwht is going on in
the mcro world?
(continued on page 24)
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Are Bonds Telling the
VIX Next Move?Mark Sebastian
insurance, everytrder wntsit, but onl few products ctu-
ll provide it. Insurnce products
dont exctl oer the best returns,
but wht the do oer is sfet. S
wht ou will bout the stte of U.S.
debt; regrdless, the owner of bond
or note will receive the full vlue of
the bond or note when the tresur
expires. It is for this reson tht, in
times of pnic, we see bonds rll to
extreme levels. another insurnce
product is S&P voltilit. When the
mrket is exploding, be it puts on the
phsicl SPX or options on VIX, the
prices of these products skrocket.
Becuse of this, there is generll
correltion of prices between the
price of the 30-er future nd the VIX,
which keeps the spred between the
two t somewht consistent level.
Similrl, tht reltionship holds true
in TLT. While the bond future is the
preferred method for trding U.S. debt
for institutionl trders, we re going
to stud the reltionship of TLT to
VIX, becuse of the continuit of price
tht doesnt exctl exist between
the futures. The bsis of futures from
contrct to futures contrct throws o
pricing just enough tht this doesnt
grph s netl. Tht sid, I think it
would behoove n serious trder to
follow up the results of our stud with
look t the reltionship between
the ZB futures contrct nd the VX
futures contrct. Tht would produce
potentill trdble pproch to swp-
ping ZB futures or options ginst VX
futures or options.
Since TLT ws rst listed, the Bond
ETF hs hd n ll time low price of
just over $81.00 shre nd hd
high price of just over $124.00 shre.
The ETF ps dividend bsed on the
ield of its bonds rther thn storing
the returns; thus the price is lmost
exclusivel bsed on where the cur-
rent long term ields re priced. at
the $124 price, long term ields re
below 4. at its price of $81 in 2003,
long term ields were MUCH greter.
as we stted bove, generll spek-
ing, the price of this product moves up
with fer nd down with clm (t lest
since the Fed begn using rtes to tr
to x the econom).
The VIX, or fer
index, represents the
cost of insuring port-
folio t n given time
using SPX options. In
times when the mr-
ket is in turmoil, the
VIX will tpicll be
hitting its pek. Over
the lst 10 ers, tht time cme dur-
ing the 2008 nncil crisis. The VIX
touched high of lmost 80; it hit its
low in times where mn thought ll
ws well. The index trded below 10
intrd in Februr 2007 before set-
tling t low just bove 10.00.
On their own, the VIX nd TLT
ech point towrd wht is hppen-
ing in the mrketplce t n given
time. It would mke sense tht the
spred between VIX nd TLT is some-
wht men reverting. Upon n opticl
scn, I noticed tht there ws direct
reltionship. a student of mine, Sm
Hrris, took m opticl observtion
nd sent me 10-er chrt of the
price of TLT minus the price of VIX. The
results produced ver cler pttern
nd distribution.
In Figure 1, we cn clerl see tht
there hs been nturl men in the
reltionship of TLT to VIX t round
7080. This mkes sense, s when TLT
Figure 1 TLTVIX
On their own, the VIX nd TLT
ech point towrd wht ishppening in the mrketplcet n given time.
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is t low price, so is VIX, for instnce
in 2007. In Feb 2007, when the VIX hit
its ll time low, TLT ws lso trding
ner its ll time low. This produced
price right round 70. Even in 2008, s
the nncil crisis unfolded, we do not
see mjor string of the reltionship
of TLT to VIX. While the VIX exploded
to over 50 nd sted there for some
time, TLT trded into the low 120s,
keeping the spred close to 70.
In fct, the reltionship is lmost
lws round 70 to 80. Sm put
together nother chrt showing where
the distribution of prices lnd.
In Figure 2, one cn see tht the
overwhelming mjorit of the time, the
price lnded in between 70 nd 80.
Figure 3 shows 3D version of Figure 2
with some dtes.
Interestingl, usull when there
ws pnic, the spred between the
two drops to ner 60 before mov-
ing bck into the 70s. We sw this
when the 2008 crisis hppened. We
lso sw the spred drop in the 2010
sh crsh, nd the spred lso fell in
august hed of Greece.
More subtl though, if one studies
the grph one might notice tht, while
initill on VIX pop the spred drops
in crisis, leding into the VIX pop,
there is subtle increse in the spred.
This is usull from the low 70s out to
the upper 70s.
This is wht mkes wht the
mrket is currentl experiencing so
stunning nd hrd to trde. The cur-
rent TLT is priced t complete pnic
levels, while VIX is onl priced t
elevted levels. This is producing
pricing spred tht is trding over 100
rights s I write this rticle. 100 is
level tht ws completel unherd
of, level tht hd never legitimtel
trded until the lst few months of
2011 nd into 2012. Essentill, while
the VIX cme o from its august of
2011 levels, bonds never esed ver
much. Even s the TLT hit its recent
lows few weeks go, the spred ws
in the 90s. Things hve gotten little
more drmtic over the lst few weeks
while the VIX hs rllied from 17-ish
to touching 25; the rll in TLT hs
pushed the spred between VIX nd
TLT to ll time highs.
Wh?
While one might point to the culprit
being opertion twist, nd I m certin
tht TWIST hs not helped, I would
point to nother culprit out here: Fixed
income still believes tht there is
mjor event bout to hppen, even
if the equit mrkets do not.
Here is the scr prt. If the
spred is now over 100, wht
tpe of VIX spike is it going to
tke to bring this spred bck
to norml?
M thoughts: I hve hrd
time seeing rtes go to 3%. I
think there is n es trde
for the pickings right now, nd
I would/m selling cll spreds
on TLT, nd t the sme time,
I m buing VIX cll spreds.
If one ws so inclined, one
could lso consider selling TLT
buing VIX, nd buing S&P
futures. I would obviousl dollr-weight
it, but I would end up owning twice s
much VIX. Bsicll, I would sell the
expensive insurnce nd bu the chep
insurnce. EM
Are Bonds Telling the VIX Next Move? (continued)
Figure 2 TLTVIX Histogram
Figure 3 VIX vs. TLT Price Frequency
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Risk or Uncertainty: Explaining the
Variance PremiumJared Woodard
inlastmonthscolumn,I explined some of the bck-
ground thinking behind the pper,
ambiguit aversion nd Vrince
Premium, which rgues tht
the vrince premium in options
prices cn be better explined in
terms of mbiguit rther thn
risk. I explined the dierence
between risk nd uncertint
in terms of the known rnge of
possible outcomes: risk situ-
tion is one in which the rnge of
possible outcomes is known to
be nite, while uncertint con-
fronts us with n unknown set of
possibilities.
The uthors of this pper
developed model designed to
test whether investor version
to mbiguit (i.e. uncertint)
provides better explntion of
the vrince risk premium thn con-
ventionl stochstic voltilit-bsed
models.
The results re promising. Recll
tht the existence nd especill the
size of the vrince risk premium is
not something tht cn be explined
b trditionl, consumption-bsed
economic models. B contrst, the
uthors nd tht the mbiguit ver-
sion model explins bout 96 per-
cent of the mrket-implied vrince
premium. Risk, i.e. stochstic vol-
tilit, explins onl bout 4 percent
of the premium. another interesting
result is tht the mbiguit version
model reproduces chnges in expect-
tions coinciding with mjor economic
swings, recessions, etc. Finll, the
model is lso tested for its relevnce
to the equit risk premium, tht is,
the return chieved bove the risk-
free rte (usull, U.S. Tresuries)
in exchnge for holding risk stocks.
Over the period 18902009, the equit
risk premium ws observed t 5.74%;
the mbiguit model produced lmost
exctl tht gure, while lso produc-
ing close estimte of the voltilit of
the equit premium (17% vs. 18.8%
observed), something the stndrd
model ws not ble to do.
One reson I pprecite the contri-
bution of this pper is tht it ccords
so well with our intuitions bout eco-
nomic ccles nd investor behvior.
Previous models hve ccounted
for observed vrince premi b
reling, not just on the ssump-
tion tht voltilit is stochstic
(rndom), but tht the voltilit
of voltilit is lso stochstic. This
rubs ginst the grin of wht
we see in the mrkets: while the
cuses of voltilit (nd of vol-
tile voltilit) re not lws es-
il discerned nd re never esil
nticipted, the re neverthe-
less cuses. Voltilit is not cre-
ted ex nihilo.
One of the implictions of this
model tht m be of interest to
trders is tht chnges in inves-
tor expecttions fter shift in
regimes, e.g. from booming to
busted econom, re likel to
persist for some time. Becuse
people hte rel uncertint, the
best time for trders to tke dvn-
tge of the vrince risk premium is
likel fter the onset of recession or
depression. This will not be shocking
news to experienced trders; however
being n option seller fter the onset
of recession is not, pschologicll,
lws so es.
The results of the pper re strik-
ing, but I wnt to rise one cution-
r g bout the model in light of the
risk/uncertint distinction. The dis-
tinctive feture of genuine uncertint
s discussed b Knight, Kenes (nd
before them, Hume on the problem of
induction), is tht in mn situtions
it is just impossible to know wht the
p a r t 2
(continued on page 24)
http://www.expiringmonthly.com/risk-or-uncertainty-explaining-the-variance-premium.htmlhttp://ssrn.com/abstract=2023765http://ssrn.com/abstract=2023765http://ssrn.com/abstract=2023765http://ssrn.com/abstract=2023765http://www.expiringmonthly.com/risk-or-uncertainty-explaining-the-variance-premium.html -
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M O N T H LY F E AT U R E
by Bill Luby
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The Early Years: Expansion by Geography and
Underlying Index
In the beginning, there ws the VIXnd for the most prt
investors were oblivious or indierent to n index tht me-
sured the mrkets expecttions of future implied voltilit.
When the VIX ws lunched, CNBC ws still in its infnc,
the Mosic browser hd not been relesed, nd the generl
publics inftution with the stock mrket ws still severl
ers w. For the most prt, investors onl checked their
portfolios when the received brokerge sttement in the
mil t the end of ech month.
Of course, the nncil mrkets looked lot dierent
in 1993 thn the do now. at the time the VIX ws creted,
the S&P 100 Index (OEX) ccounted for bout 75% of ll
index options trdes (compred to just 16% for the S&P 500
index), so it ws nturl tht the VIX ws linked to the OEX.
Over time, the OEX begn to be displced b the S&P 500
index (SPX) nd the VIX broke from its moorings nd slowl
drifted w from the center of the equit index universe.
While the VIX hd no domestic competitors, it ws not
long before its rst interntionl peer ppered on the
scene. In December 1994, the Germn Futures nd Options
exchnge lunched the VDaX, bsed on the Germn equit
index, DaX, which consists of 30 lrge cpitliztion Germn
compnies trding on the Frnkfurt Stock Exchnge.
Interestingl, the VDaX did not follow the CBOEs VIX cl-
cultion methodolog. In fct, in its originl form, the VDaX
used the Blck-Scholes model nd focused on t-the-mone
options to generte 45-d estimte of implied voltilit
for the DaX.
Competition in the domestic voltilit index spce did
not rise until 2001nd once gin it ws the CBOE tht
ws behind the new index. When it ws lunched in Jnur
2001, the CBOE NaSDaQ-100 Voltilit Index (VXN) ws
rgubl better mesure of mrket voltilit thn the VIX.
The Vixen ws born in the middle of the tech meltdown,
t time when smll cp nd technolog stocks were led-
ing the mrket down nd the S&P 100 ws reltivel stble
b comprison. For the rst four months of 2002, the VXN
verged bout double the voltilit recorded b the VXO.
Even s the two indices strted to converge, in June 2002,
the VXN ws s high s 66.19, while the VXO never mde it
n higher thn 35.99. as technolog stocks continued to
fll nd drg the broder mrkets down with them, the VXN
provided more pointed brometer of the voltilit tht ws
rvging the mrkets during the dot com bust.
Lunched within 24 hours of ech other, the CBOEs VXN
nd the americn Stock Exchnges QQV (which ws bsed
on QQQ, the populr ETF for the NaSDaQ-100) hinted t the
possibilit of voltilit products rms rce between the CBOE
nd the aMEX. This never cme to fruition, s the CBOE out-
nked the aMEX nd soon cme to dominte the voltilit
index mrket. Tht domintion begn when the CBOE revo-
lutionized the concept of voltilit indices in 2003.
Rebuilding the Foundation in 2003
The two issues tht most hmpered the growth nd develop
ment of the VIX were:
1. the link to n underling index tht ws declining in
importnce; nd
2. clcultion methodolog tht focused onl on ner-
the-mone strikes
The CBOE remedied these shortcomings in September
2003, when the mde two criticl chnges to the VIX, sub-
stituting the SPX for the OEX, nd expnding the rnge of
strikes involved in the clcultion to include ll SPX options
quoted with non-zero bid prices. The net result of these
modictions ws to tie the VIX bck into the most impor-
tnt benchmrk equit index nd to mke the VIX clcul-
tion reect the full rnge of trdble SPX options in such
mnner tht the skew of the out-of-the mone SPX strikes
ws included in VIX clcultion.
The reformultion of the VIX clcultion methodolog
ws joint eort between the CBOE nd Goldmn Schs.
Not surprisingl, one of the outcomes of the reformultion
of the VIX ws tht it becme more useful to institutionl
investors, s the new VIX clcultion methodolog mde
the VIX conform more closel to institutionl prctices nd
specicll mde the VIX n pproximtion for the vrince
The Expanding Volatility Megaplex (continued)
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swp rte tht is included in mn institutionl derivtives
products.
The CBOE indicted tht not onl were the interested
in modifing the VIX to provide more precise nd robust
mesure of expected mrket voltilit, but the were lso
explicit in stting tht one of the gols of reformulting the
VIX ws to crete vible underling index for trdble
voltilit products. Following tht line of thinking, the CBOE
lunched VIX futures in Mrch 2004 nd dded VIX options
in Februr 2006.
Expanding the Volatility Universe: 20052008
Following the lunch of VIX futures, the CBOE embrked
upon n ggressive cmpign to expnd their voltilit
index frnchise, rst b expnding the bse of the underl-
ing equit indices, then b expnding the time horizon for
the voltilit clcultion nd nll b moving beond equi-
ties into commodities nd currenc.
The rst step in this expnsion ws to roll out voltilit
indices for some of the mjor mrket indices. In M 2005,
the CBOE lunched VXD, bsed on the Dow Jones Industril
averge nd in M 2006, RVXwhich is bsed on the
Russell 2000 indexws dded to the mix.
The CBOE then chrged o in completel dierent
direction nd in November 2007 lunched the CBOE S&P
500 3-Month Voltilit Index (VXV). VXV is identicl to the
VIX in ever respect except tht it looks forwrd 93 ds,
compred to the 30-d window for the VIX.
The following er, however, mrked the biggest lep for
the CBOEs voltilit index expnsion strteg. In Jul 2008,
with West Texs Intermedite crude oil trding in the $140
per brrel rnge, the CBOE lunched the CBOE Crude Oil ETF
Voltilit Index (OVX). This voltilit index is bsed on the
United Sttes Oil Fund ETF (USO) nd ws dubbed the Oil
VIX b the CBOE right from the initil press releses. The
following month, the CBOE dded the Gold VIX nd the
Euro VIX to the stble. The former, which goes under the
ticker GVZ, is bsed on the populr gold SPDR Gold Shres
ETF, GLD; the ltter, whose ticker is EVZ, is bsed upon the
CurrencShres Euro Trust ETF, FXE.
Whether b luck or design, these new voltilit indices
just mnged to get out of the gte before the nncil cri-
sis of 2008 struck in ll its fur, leving dozens of new vol-
tilit records in its wke.
VIX Goes Mainstream During the Financial Crisis
of 2008
While voltilit ws growing in importnce nd notoriet prior
to the 2008 nncil crisis, it ws the crisis tht ctpulted the
VIX onto the center stge. as stocks plummeted nd investor
nxiet spiked cross the globe, the VIX cemented its reput-
tion s Wll Streets fer guge. The VIX quote becme
xture on CNBC nd fodder for nlsts from ll corners of the
medi who were seeking mens b which to evlute the
degree of uncertint nd pnic in the nncil mrkets.
With the incresed ttention being pid to the VIX, the
trding volumes for VIX futures nd options surged, s hedg-
ers nd specultors ocked to products tht demonstrted
convexit b being showing more dnmic upside moves
nd muted downside moves. This convexit ws prticulrl
ttrctive to institutionl investors who sought investments
with strong risk mngement prole.
For the most prt, retil investors continued to see the
VIX s more of mrket indictor during the nncil crisis
thn suite of products which could esil be trded. Tht
ll chnged in erl 2009 with the rst VIX exchnge-trded
products.
The VIX Exchange-Traded Products Revolution:
2009Present
Brcls introduced the rst VIX two exchnge-trded notes
(VXX nd VXZ) to ver little fnfre in Jnur 2009. These
products were mde possible b the cretion of two voltil-
it strteg indices b S&P Indices tht were developed with
n ee towrd VIX futures strtegies tht could be trnslted
into exchnge-trded products: the S&P 500 VIX Short-Term
Futures Index; nd the S&P 500 VIX Mid-Term Futures Index.
Over time, VXX nd VXZ grdull cptured the imgin-
tion of retil investors nd spwned grnd totl of more thn
thirt voltilit-bsed exchnge-trded products in the United
The Expanding Volatility Megaplex (continued)
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Sttes lone. The beut of these products is tht the mr-
ket mkers who sold them tpicll hedged these sles with
osetting positions in the VIX futures mrket. With VIX-bsed
ETPs frequentl trding in excess of 100 million shres per
d, the direct impct on VIX futures volumes cn be substn-
til. Through the end of april, for instnce, trding volumes in
VIX futures contrcts were up 68% over the previous er.
The Expanding Volatility Megaplex
In 2011, the CBOE took perhps its biggest gmble in
expnding the scope of voltilit indices, electing to list vol-
tilit indices on ve individul equit options in Jnur nd
six populr ETPs in Mrch, ll of which utilize the VIX clcu-
ltion methodolog. These VIX-stle indices trgeted some
of the most ctive nd sstemicll importnt individul
stocks, while the ETP indices focused on the dul themes of
emerging mrkets nd commodities. (See Figure 1 below for
the full list of single stock nd ETP-bsed voltilit indices.)
It ppers tht fter n pproch to blnketing the equit,
commodit nd currenc universe in serch of brod line
of diversied voltilit index products, the CBOE hs recentl
shifted to strteg in which trding volumes nd liquidit
re the min focus. In fct, in the cse of individul stocks
nd prticulrl ETPs, the list of new voltilit indices coin-
cides lmost perfectl with list of most ctive options. With
volume nd liquidit gols the driving force behind voltilit
index expnsion, this mkes it esier for the CBOE to focus
on the top volume issues nd pursue lterntive pproches
for res where demnd is still unproven, s ws the cse
with the Ntionl Stock Exchnge of Indi, which licensed the
VIX methodolog for the Indi VIX in 2008.
Bsed on recent success stories, the mgic formul for
voltilit indices seems to be centered upon creting prod-
uct pltform on which futures cn be built tht will ttrct
exchnge-trded products which include voltilit futures
in their portfolio. Here trnsctions in the ETP mrket re
hedged in the underling futures mrket, driving up volumes
nd tightening spreds in the futures mrket s prt of
virtuous ccle. In order to mke this hppen, criticl link
in the process hs been for the S&P Index group to crete
futures-bsed indices tht trget xed mtu-
rit nd utilize sttic nd sometimes dnmic
lloctions mong the holdings of the index.
To some extent, one cn look t where
futures (nd options) hve been lunched to
get sense of which res the CBOE believes
is most promising. at present, VIX futures
ccount for pproximtel 99% of ll vol-
ume on the CBOE Futures Exchnge (CFE),
where the voltilit index futures contrcts
re trded. The second most ctivel trded
futures contrct t the CFE is bsed on the
CBOE Emerging Mrket Voltilit Index, VXEEM.
The CBOE Brzil ETF Voltilit Index (VXEWZ)
nd the CBOE Crude Oil ETF Voltilit Index
(OVX) hve lso seen some investor interest
s of lte, but doption hs been slow in both
instnces.
In recent news, the CFE nnounced on
M 17 tht it plns to lunch trding on the
The Expanding Volatility Megaplex (continued)
Figure 1 The Evolution Volatility Indices
VIXandMore
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CBOE NaSDaQ-100 Voltilit Index futures contrct begin-
ning on Wednesd, M 23, pending regultor pprovl.
Bsed on VXN, these futures give the CBOE the more expo-
sure to the voltilit component of the red-hot technolog
sector, where the likes of apple, Fcebook nd Google hve
been ttrcting gret del of investor ttention s of lte.
Conclusion
From its humble origins, the VIX hs grown to become
dominnt force in the futures nd options spce. Recentl,
the ddition of VIX-bsed ETPs hs extended the VIX product
pltform nd chnneled new source of volume into the VIX
futures mrkets.
Up to this point, the CBOE hs hd dicult replict-
ing the success of the VIX in other voltilit indices, though
eorts hve been mde to extend the voltilit pltform
cross other mjor mrket equit indices, commodities, cur-
renc, individul stocks nd vriet of exchnge-trded
products. I think it is sfe to s tht the CBOE is intent on
tring to crete multi-dimensionl voltilit pltform, ide-
ll one tht spns sset clsses nd includes brod-bsed
indices, ETP sector nd geogrphicl groupings, s well s
individul stocks.
The relit is tht n product tht hs options ssoci-
ted with it hs implied voltilities tht cn be esil clcu-
lted. Provided there is sucient liquidit, n optionble
securit could esil hve multiple dt strems ssoci-
ted with it. The obvious ones, of course, re the price nd
volume of the underling. With options comes n dditionl
set of prices nd volumes, s well s open interest. There is
no reson wh some sort of men implied voltilit clcul-
tion cnnot be ssocited with the underling too, so tht
ever optionble sset lso hs its own VIX-stle voltilit
clcultion.
The rel question revolves round wht tpe of demnd
there is for futures nd exchnge-trded products bsed on
voltilit indices other thn the VIX.
While the new voltilit indices m be boon to options
trders who like to trde voltilit, the demnd for voltilit
indices on ech nd ever optionble stock, ETP, index, com
modit, etc. is lrgel unproven.
The big wild crd in this scenrio is the emergence
of ETPs nd the bilit of the voltilit index futures nd
relted ETPs to reinforce ech other in virtuous ccle tht
increses volumes nd keeps bid-sk spreds to minimum.
The VIX ETP spce hs proven to be irresistible to hedge
funds nd individul investors using short-term trding strt-
egies. With even greter exposure to voltilit, the emerging
mrkets voltilit index VXEEM nd the VXEM futures should
be n excellent test of the expnsion potentil of the voltil-
it index product pltform.
Looking pst VXEEM, there is lso the potentil for
success with VXaPL, the apple StockVIX. The other
re where potentil interest in voltilit indices remins
untpped is the nncil sector. Here it is es to imgine
voltilit indices bsed on XLF, the populr ETP. Voltilit
indices re lso possible on individul stocks such s
JPMorgn Chse, Bnk of americ nd Citigroup.
Voltilit indices hve been n unqulied success s
mrket indictors nd to lesser extent s product pltforms.
The recent explosion in voltilit indices mrks criticl new
stge in the development of these indices nd renewed
eort to replicte the VIX product pltform cross other vol-
tilit indices. So fr investors hve shown limited ppetite
for the new products, but if exchnge-trded products linked
to voltilit index futures cn ttrct the interest of investors,
it m usher in n even lrger voltilit megplex in which
the VIX is but one of mn product pltforms. EM
f r
Comprtive Implied nd Relized Index Voltilit,Expiring
Monthly, april 2012.
Trding the Expnding VIX Products Spce, Expiring Monthly,
September 2011.
VIX Convexit,Expiring Monthly, June 2011.
Evluting Voltilit across asset Clsses,Expiring Monthly,
Mrch 2011.
The Expanding Volatility Megaplex (continued)
http://www.expiringmonthly.com/comparative-implied-and-realized-index-volatility.htmlhttp://www.expiringmonthly.com/trading-the-expanding-vix-products-space.htmlhttp://www.expiringmonthly.com/vix-convexity.htmlhttp://www.expiringmonthly.com/evaluating-volatility-across-asset-classes.htmlhttp://www.expiringmonthly.com/evaluating-volatility-across-asset-classes.htmlhttp://www.expiringmonthly.com/vix-convexity.htmlhttp://www.expiringmonthly.com/trading-the-expanding-vix-products-space.htmlhttp://www.expiringmonthly.com/comparative-implied-and-realized-index-volatility.html -
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Expiring Monthly Interview with
Mark SebastianJared Woodard
You know Mark Sebastian as one of
the co-founders and editors of Expiring
Monthly, but he wears many other hats,
too. He runs a successful mentoring
and education company called Option
Pit, consults as a risk manager for a
hedge fund, writes for The Streets
Options Prots team, and has become
a sought-after media commentator
as well. I got the chance to ask Mark
about his own trading, his new book,
and some other topics that I hope you
will enjoy.
Jaed Woodad fo Expn
Monthly: How did you get started in
trading? Why options?
Mak Sebastan: In m junior er
of college, I ws intent on getting into
investment bnking nd ws inter-
viewing with Goldmn Schs, Ber
Sterns, etc. at the end of tht er,
professor pulled me side nd sked
me to tke new clss he ws strt-
ing: Finncil Derivtives. While this
m be semi-common course now
t colleges, it rell didnt exist on n
cmpus 11 ers go. The moment
we begn digging into options, I ws
hooked, nd I decided I wnted to be
trder. I ws hired b Group 1 Trding
into their Mrket Mker trining pro-
grm nd er lter, I ws on
bdge trding options in the GE pit on
the americn Stock Exchnge.
JW: One of things I like about Option
Pit is that you oer mentoring services
for traders at several dierent levels
not just the standard introduction to
options for novices. What kinds of
things can an experienced trader learn
at Option Pit?
MS: at Option Pit, we concentrte on
being ble to service n client tht
sees us. For the low end trder, tht
mens rell lerning to understnd
the mechnics of options. For high
end trder, the biggest nd most com-
mon filing is the inecient use of cp
itl. Mn trders tht hve portfolio
mrgin dont know how to use it prop-
erl. The use of PM should ctull
reduce risk for trdernot increse
riskbecuse it llows the trder to
full trde three-dimensionll: not
just verticll cross months, but the
bilit to trde the months bck nd
forth ginst ech other. We lso oer
risk consulting services; in this service
we bsicll re hired to poke holes
in mone mnger, hedge fund, or
high net worth individuls trding
pproch. Our institutionl customers
love this service.
JW: A lot of options traders are just
leveraged technical analysts in dis-
guise, or long-term fundamental inves-
tors using options to control risk. What
sorts of research or analysis do you
rely on to create an edge in your own
trading?
MS: While trders need to hve t
lest mild knowledge of technicl nl-
sis, we onl rell look t it becuse
other trders re looking t it. The
technicls we look t for our option
trdes re lmost exclusive voltilit
nlsis. We stud where implied vol-
i n t e r V i e w
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tilities re reltive to relized
voltilities. We stud where
IVs re reltive to historicl
IVs nd where HVs re rel-
tive to historicl HVs. Bck to
our three dimensionl discus-
sion: studing voltilit, we
lso look t the term struc-
ture nd the reltionships of
voltilities cross months.
JW: What are your favorite
products to trade? Are there
any products you think trad-
ers should avoid?
MS: I love trding SPX,
SPXPM; I like the VIX ETNs
nd VIX options nd futures
themselves. I do not think
there is n product tht
retil trders should void.
In fct, I hve found tht if
there re people out there
telling retil trders to
void product, it is worth
reserching; guring out
wht is cusing problems
for retil trders nd then trding the
product. a misunderstood product is
protble product.
JW: What is it like being the risk man-
ager at a hedge fundwhat is an
average day like in that role? Does
that mean checking in periodically to
atten deltas, monitor position sizes,
check asset correlations, or what? How
do you manage the risk of an open-
ended position: say a trader has sold a
bunch of at the money straddles? How
do you estimate the risk in that situ-
ation: a VaR model, a hard dollar P/L
stop, or something else?
MS: Working risk for hedge fund
cn be fun nd cn lso be frustrting.
One of the issues I hve hd on the
risk consulting side is tht I dont hve
hrd control over risk in the w tht
mn hedge fund risk mngers do.
If I were to ocill work for hedge
fund I would need to be empowered t
level tht I could force trdes, some-
thing I hve been unble to do on the
consulting side. Tht sid, when
I m consulting I hve found tht
ech client is dierent. Some
need hrd dollr or percent levels
some need to hve price point
stopit vries. I like to combine
combintion of veg risk, gp risk
nd run risk when I m evlut-
ing the risk of position. The ke
to n position, in fund or in
personl ccount is to never let
position get out of hnd ndthis
is even more importntlws
be ble to keep trding.
JW: Drawing on your experience
mentoring other investors, what
are some topics or concepts that
tend to be harder to grasp? Are
there any areas where people are
more likely to make mistakes?
MS: The hrdest thing new trd-
ers nd to grsp is the pric-
ing model, snthetics, nd the
Greeks. Snthetics re hrd
becuse no one seems to wnt
to tech it. Despite the fct tht
it goes mostl ignored, n understnd-
ing of option snthetics remins the
ke to understnding options s
whole. One reson, I think, tht mn
trders lose so bdl in options is tht
the re never tught foundtionl
understnding of how options ctull
price: bd foundtion, bd everthing
else. To mke mtters worse, there re
mn progrms tht tech how the
Greeks work without teching how the
pricing model works. Without rm
understnding of the option pricing
Expiring Monthly Interview with Mark Sebastian (continued)
The OpTiOn Traders
hedge Funda Business FramewOrk FOr
Trading equiTy and index OpTiOns
Dennis A. Chen | MArk sebAstiAn
I :
I :
http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1http://www.amazon.com/The-Option-Traders-Hedge-Fund/dp/0132823403/ref=sr_1_1?ie=UTF8&qid=1332259909&sr=8-1 -
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model, there is rell no w to under-
stnd or evlute risk. This is becuse
the Greeks, the tools option trders
use, ctull come from the pricing
model. Too often retil trders rel on
grph tht is n output of pricing
model, without understnding tht
the risk grph cn chnge on them.
Without understnding snthetics nd
the model, risk grphs rell re
dngerous tool becuse trders think
the re fir evlution of risk, which
the re not.
JW: We see a lot of news these
days about changes at the options
exchanges: new exchanges open-
ing and being proposed, lawsuits over
products, the payment for order ow
controversy, etc. Why should an aver-
age investor care about any of that?
MS: The ke issue there is order ow.
In n rticle clled The Future of
Options Exchnges nd lso some-
thing tht I brie discuss in m new
book, The Option Traders Hedge Fund,
I point out wh order routing mtters. It
ll stems from Pment for Order Flow,
the prctice of ping brokers to route
orders to one exchnge or nother.
Generll speking, there re two
tpes of exchnge models, the tke
model nd the mke model. Tke
model exchnges p for orders tht
tke liquidit. Mke model exchnges
p for orders tht mke liquidit.
Needless to s, tht puts order rout-
ing in position to be in conict with
best execution prctices in their tru-
est sense of the word. Tke exchnges
tpicll hve ll of the liquidit while
mke exchnges hve ver little liquid-
it. yet, time nd time gin, becuse
of the contrdicting models we see
orders routed to exchnges with little
to no liquidit s brokers tried to get
pid on the mke.
JW: Tell us more about your forthcom-
ing book. How is this book dierent
from previous books on options?
MS: The book is dierent in tht it hs
little to nothing to do with the wht
of options nd lot to s bout the
how in options trding. Dennis nd I
spend lot of time tlking bout how
one needs to mnge their mone,
evlute risk, nd execute nd struc-
ture trdes. Our book is lmost like
hedge funds cookbook. It will give
trders ll the knowledge the need
in order to build serviceble option
trding business, long with the nec-
essr knowledge not to blow up their
ccount in the process. While no book
cn truthfull s tht it teches trd-
ers how to mke mone, our intent is
to come s close s humnl possible
to chieving this gol. Consider this
the rst hndbook for the option-inten-
sive hedge fund.
JW: Who is the intended audience?
MS: Our intended udience is trders
tht wnt to lern to think nd trde
like professionls. It is not begin-
ners book on n level nd is probbl
lmost n dvnced book. It is ment
to be follow up book to the Option
Voltilit nd Pricing books from
Ntenberg or McMilln. Wht I like
bout it, nd wh I think it hs brod
ppel, is tht lmost ever trder
retil, prop, or mone mnger
should lern to think bout options the
w professionl does.
JW: What are your favorite parts of
the book?
MS: The sections I rell like re the
prts tht involve mone mngement
We go into gret detil on how to mn-
ge mone t the portfolio level, nd
the individul trde level. I lso love
the lessons from the pit sections.
We took some of m old blogs from
Option Pit nd rewrote, updted, nd
pplied them to the frmework of the
book. Mn chpters led from lesson
to rel life experience tht hppened
s I ws trding or teching tht I
wrote bout.
JW: Thanks, Mark. EM
Expiring Monthly Interview with Mark Sebastian (continued)
The ke to n
position, in fund
or in personl
ccount is to neverlet positionget out of hndndthis is even
more importnt
lws be bleto keep trding.
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How Liquidity Providers
Price OptionsAndrew Giovinazzi
lastmonthicovered the tech-nolog chnges tht hve occurred on
the trding oors over the lst 20 ers
or so (t lest s long s I hve been
round in the option business). Most
of tht discussion revolved round the
pipes nd chnges going into the deliv-
er of informtion nd quotes. I think
it mkes sense to follow up tht piece
this month on how liquidit providers
price the options in the rst plce.
Pricing In the Old Days
Option pricing prior to the dvent of
Blck-Scholes ws bit more hurl
burl. The old timers I tlked to when
I strted in the lte 80s clled it, of
course, the good old ds. Things like
OTM options sting bid long pst their
chnce of nishing in the mone were
reltivel common. Vluing options b
pure feel nd rithmetic ws gret
exercise in snthetic reltionships. The
reversl/conversion, butter nd box
prett much ruled in the 70s nd 80s
s the min position mngement
vehicles. From the beginning, even
prior to Blck Scholes, the one thing
tht hs remined constnt ws the
need to estblish some tpe ofrelative
relationship for liquidity providers. The
dvent of the R/C, butter nd box
helped trders get grsp on the pric-
ing of one option reltive to the price
of nother. after ll, t expirtion those
reltionships will move to either prit
or expire worthless. B using snthetic
techniques trders could sell wht
the thought ws the expensive option
nd bid for the reltivel cheper
option nd be left with position with
reltivel little risk. This llowed some
liquidit to form in prticulr option
clss.
The mrket for clss of options,
lets s IBM (since there is some nos-
tlgi there) looks like this:
33 IBM Jul 205c
11 IBM Jul 210c
1IBM Jul 215c with IBM trdinground $197 in mid-M
The current bid on the IBM Jul
205/210/215 Cll Butter is bid the
liquidit providers w (buing on the
bid nd selling on the oer). The ide
for butter (bck then or tod) is
to bu the position for the smllest
debit possible ( credit is idel since
the position is virtull ssured of
mking mone). With ernings coming
out the IBM Jul 210c go bid to $2 lev-
ing the new mrkets this w:
33 IBM Jul 205c
22 IBM Jul 210c
1 IBM Jul 215c
Note how tht chnges the price of
the IBM Jul 205/210/215 Cll Butter
to credit the liquidit providers
w. Tht is wht trders cll edge.
Buing options in one plce nd sell-
ing them for quntible dvntge
is edge nd it is wht ll good trders
look for. The mrket mker or spe-
cilist cn now bid up the other cll
mrkets to keep putting on the posi-
tion. With this much edge nd willing
buers of the 210s, the LPs could step
up nd build lrge positions, provide
liquidit to other series nd crete n
orderl mrket. This whole process
would tke couple of seconds. a
ke prt for ll this working is pricing
round the current order ow. Tht is
the lever on which the mrkets move.
This leds to one of m trding rules:
The active strike drives the pricing.
Pricing Options In the Advent
of Auto Quote
With couple of rules in plce on rel-
tive vlue nd ctivit, pricing options
evolved to n exercise in mnging
the implied voltilities of the trded
series. auto Quote mde it es to just
plug in forwrd voltilit number into
the quote mchine nd out popped
whole clss of mrkets bsed on Blck
Scholes (or whichever model dpt-
tion the trding pit ws using). But the
sme problems of liquidit nd price
discover remined. Trders were
now posting mrkets on where the
thought the fair value of implied vola-
tility was trading at the time.
The new mrkets looked like
this from the liquidit providers
prospective:
3 (20%)3 (23%) IBM Jul 205c
2 (29%)2 (33%) IBM Jul 210c
(20%)1 (23%) IBM Jul 215c
Insted of the more rithmetic
intensive ctivit of pricing snthetics,
trders strted just trding the vol-
tilit. The public (tht mens ever-
one who is not n exchnge member)
f l o o r s t o r i e s
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just sw the price quotes but trders
looked t pricing in n evolving light.
The sme customer in the 1970s p-
ing 2 for the IBM Jul 210 clls ws
now ping 33% Implied Voltilit.
Trders hd dierent tool to guge
customer interest since implied voltil-
it is esier to trck, remember nd
record reltive to underling moves in
the underling.
Trding positions got bit more
complex thn the reversl/conversion
crds of the old ds since new expo-
sures to risk were not necessril t
contcts or voltilit exposure. Mrket
positions mesured in exposure to
Veg (the chnge in n option price for
1-point chnge in voltilit) begn
to tke over s liquidit providers got
more grnulr in their pricing. Trding
for edge now ment selling higher IV
nd buing lower IV nd spreding
the risk o in the whole clss b dd-
ing positions in the outling months.
Pricing Options Now with the
Electronic Eye
Estblishing some reltive vlue is the
most importnt step in pricing options.
The dvent of full utomted mr-
ket mking tht exists tod tkes
ll of this to new degree nd speed.
Essentill think tht option pricing is
generted b computers tht re mn-
ged b people. The rules for nding
edge still ppl. If no edge exists in
the current pricing, the LPs move the
implied voltilities until the suppl nd
demnd curve come into equilibrium.
Wht hppens now is tht the shifts in
voltilit re ver fst nd ver erce
in generl. One of best ws to trde
this from the prop side is simpl just
witing until the mrkets get pushed
in prticulr direction nd then posi-
tion in n ctive nme. Looking for
edge now is more function of keep-
ing n ee out until pper hs strted
to stretch the mrkets bit.
Most professionl trding sstems
re now looking for pper in the con-
fb of the vrious exchnges. The re
set up with n electronic ee to scour
mrkets to lift smller order ow tht
ts the theoreticl vlue nd voltil-
it prole of tht prticulr liquidit
provider. Once sh of liquidit hits,
the sstems still hve to djust s the
reclibrte wht new edge looks
like. Trders now hve dierent ccess
speed nd pricing bilit but re still
looking for the sme thing the lws
hve, which is to nd reltive edge
in the mrket. Buing low nd selling
higher never goes out of stle but wit
to do it now is bit dierent. EM
How Liquidity Providers Price Options (continued)
Trders now hve dierent ccess,
speed nd pricing bilit but re stilllooking for the sme thing the lws
hve, which is to nd reltive edgein the mrket.
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Gundlach on Apple and
Natural GasJared Woodard
inaspeechatthe New yorkycht Club in lte april 2012, well-
known fund mnger Je Gundlch
presented slide compring the price
of apple stock since 2009 with the
price of Google since 2004.
The comprison is ttention-grb-
bing, nd the recent hsteri bout
apple is fmilir when we think bout
the sentiment towrd Google in its
erl ds. But wht rell cught
everones ttention ws the comment
Gundlch mde next:
If I were one of these crz hedge
fund gus, with the slick hircuts nd
fnc shoes nd rcing stripe shirts,
the trde Id put on is 100-times-lev-
erged nturl gs long versus 100-
times short apple.
The reson for the comment, s
he explined in n interview severl
weeks lter, ws tht t the sme
time sell-side nlsts were tring to
out-do ech other with ever-higher
apple price trgets, other nlsts
were lso competing to see who would
be the rst to price nturl gs t
$0.00. There is trend-following, nd
then there is blind fith. We cn ctu-
ll quntif the unusul nture of the
nturl gs/apple reltionship: Figure 2
plots the log rtio of UNG/aaPL shres
since 2007.
Notice two things bout this chrt.
First, the log rtio is so smooth tht
liner regression gives us n R^2
vlue of 0.94. Second, t the time
Gundlch clled for this trde, the
reltionship hd swung to n historicl
extremenot just lower thn t n
f o l l o w t h a t t r a d e
FigurE 1 Google vs. Apple
FigurE 2 Log Ratio of UNG/AAPL Daily Closing Prices, 20072012
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time in histor, but lso fr, fr below
the regression line. Wht sounded like
hlf-joking gmble turned out to be
ver resonble men reversion pl.
Not wnting to tke on the risk
or tie up the cpitl needed for
strightforwrd long UNG / short aaPL
position, on M 9th I put together
version of the sme position using
options. We bought the aaPL Jul
565/505 put verticl t net cost of
$20.15 nd bought the UNG Jul 17
clls for $1.82. 11 UNG clls were
bought for ever 1 aaPL put spred. at
the time of entr, the apple puts were
priced round 31% implied voltilit,
which ws bout verge compred
to the lst ers worth of observ-
tions. Nturl gs implied voltilit hd
lred jumped up fir mount, but
since the trde thesis clled for bot-
tom in gs prices, being long voltilit
ws the onl w to go.
Figure 3 shows our trde entr
nd how the reltionship hs fred
since then. The position hs obviousl
worked out well: the aaPL put spred
is bsicll t brek-even but the UNG
clls hve exploded higher long with
nturl gs prices. a 111 lloction
to the position (the smllest possible)
is up bout $775.
With bout 60 ds remining
until Jul expirtion, I m comfortble
holding onto the position bit longer
before rolling everthing into lter
ccle to void too much time dec.
The UNG clls re now lmost $2 in
the mone nd the long strike of our
aaPL puts is t the mone, so there
is still plent of juice left in this trde,
delt-wise.
I wnted to review this position
becuse its bsed more on sttis-
ticl reltionship nd on the fund-
mentls of the ssets rther thn the
pure voltilit nlsis tht we usu-
ll cover; I prefer the ltter, but hve
spent more time in the lst er look-
ing t fundmentl dt before mking
trdes. In the cse of nturl gs, the
scndl t Chespeke nd the suppl
relief hve voided wht could hve
been disstrous summer for nturl
gs prices. I like apple s much s the
next gu (I think I ws the onl kid in
m town growing up who hd n apple
IIGS), but the revivl-tent nture of the
stock rll nd ttendnt medi cover-
ge did wrrnt some skepticism.
The question tht remins is wht
to do in three or four weeks when it
comes time to roll the position. M
rst step will be to check in on the
rtio nd where it is in reltion to the
regression line. Bsed on the chrt t
Figure 2, complete reversion higher
would tke the log rtio to -3.20 or -3,
depending on time, which is where
it ws in lte Jnur. Thts quite
bit more upside potentil, even if we
ignore or den Gundlchs comment
tht this trde hs monster legs.
assuming the reversion higher con-
tinues, I will probbl keep some long
nturl gs exposure but strt trim-
ming the short apple position more
hevil. EM
Gundlach on Apple and Natural Gas (continued)
FigurE 3 Log Ratio of UNG/AAPL Daily Closing Prices, 20112012
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The Education
BusinessMark Sebastian
earlierthismonthI wsquoted in piece for Bloomberg
Businessweek titled: americns Es
Mrks with Options Inspired b Powell
nd Bush. While I ws slightl mis-
quoted in the piece (I stted tht
bout 10% of ll those who tr to trde
options will bet bnk ccount, not
m own students), the misquote led
me to thinking bout how relistic we
ll re with our nnces. Writing for
this mgzine we hve t n given
time four of the best trders in the
business discussing options, et I cn
promise ou tht ech of us hs hd
losing ds, months, nd in m cse
losing ers (I hd terrible 2008). yet,
how often do we in the nncil press
tlk bout our big losers? I cn tell ou
this much, its rre . . . nd we re the
GOOD GUyS!! If the good gus re not
tlking bout their losers, then how in
the world is the newbie option trder
supposed to be ble to decipher the
good gus from the bd gus?
This leds me to the next big ide
I think could mke lot of sense for
mrketing to retil trders: pitch the
truth. This doesnt men tht the hon-
est gus hve to wlk round sing
He, everone, I m n idiot,
but mbe it might mke sense for
those of us good gus to write bout
the losers we hve s often s the win-
ners, even if there re fewer losers in
the bunch. Wh? Becuse it will be
possible to do something tht I hve
thus fr hd big problem estblish-
ing with potentil clients: relistic
expecttions.
The retil public hs totl lck of
wht is relistic expected return for
portfolio mnged b n individul
investor. Much of the blme lies on the
scumbgs in the rticle bove. The
use few tricks tht mke big returns
seem es.
The will often l out $10,000
portfolio nd show some sort of
phenomenl return. Wht theleve out is the risk involved in
the trde. The dont let the retil
trders know tht there is big dif-
ference between trding $10,000
portfolio nd $1,000,000 portfolio
on this pproch.
The lso leve out interd nd
intermonth swings. It is es to
show gret theoreticl return
when the trder simpl closes his
or her ees nd comes bck 30
ds lter. This leves out the men-
tl impct of wtching position.
Often, the time period of the trde
is selectivel chosen. I cn es-
il show none how to mke
lot of mone being short VXX or
long XIV s long s the time period
is November of lst er through
april of this er. If the time period
is the month of M in 2012, I mgoing to hve lot more trouble
showing gret return.
But the biggest lie is probbl in
the degree of dicult these rms
pitch. I went through er of trin-
ing before getting on bdge. Jred
nd Bill spent ers lerning this
business before the got rell good
t it. andrew ws trding before
there were puts so Im not sure
wht his stor is (kidding). The point
is tht we re ll ver experienced
t trding nd we still lose some-
times, nd certinl none of us re
oting 250% returns nnull, e
fter er (lthough I believe we ll
hve probbl hd n mzing er
here nd there). The truth is tht
trding is hrd, nd n sles pitch
tht ss nthing dierent is lie.
So wh strt posting our losers if
ll of the scumbgs pitch how es
it is to win? We cnt sve everone,
lets fce the fcts, some people re
stupid nd ment to be hd. It cn
esil hppen to none (heck, I hve
Theter Innovtion Stereo ling
round m storge re somewhere).
However, I believe tht most people
rent stupid; if the bulk of the hon-
est ones strt pointing out wht its
rell like out there, prett soon the
scumbgs re going to be gretl
wekened or stright up out of busi-
ness . . . good. EM
B a c k p a g e
The truth is thttrding is hrd,nd n sles
pitch tht ss
nthing dierent
is lie.
http://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.htmlhttp://www.bloomberg.com/news/2012-05-02/americans-easy-marks-with-options-inspired-by-powell-and-bush.html -
7/27/2019 Expmonthly Vol3no3 May 4 5
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Managing the Short Time Spread (continued from page 7)
Risk or Uncertainty: Explaining the Variance Premium (continued from page 10)
If the risk mnger looks t it from
the underling move perspective it
shows up s big positive.
Are the Conditions Right for a
Short Time Spread?
Where does this leve us right now in
the middle of M going into the June
ccle in the big indexes? While there
is some chop right now, IV is reltivel
high, but most likel will not be ble to
nnce the level through June expir-
tion. No Greek election news for the
June ccle mens possible test to lows
nd some downside but not rel col-
lpse since the mrket is still short
reson. at the sme time Greek elec-
tions re fter the June ccle so those
months will st elevted until the
Greeks decide their own fte. This
is not the recipe for the short time
spred becuse there is not enough
movement ner term with voltil-
it collpse, t lest not et. There re
other ws to fde this Greek Trged
but I dont think on M 22nd tht the
short time spred is the right pl. For
now I think JPM might gree. EM
rnge of outcomes might be. Its not
just tht we cnt predict the future;
its tht we cnt even tell where pos-
sibilit spce ends nd impossibilit
begins.
B developing model to mesure
investor version to uncertint, the
uthors m well hve found bet-
ter w of explining historicl mrket
prices. But, s with n quntittive
model, its vlue in the future will onl
ever be function of ever-chnging
investor ttitudes. as result, the
model itself is onl s stble s ggre-
gte investor pscholog. The mbi-
guit version model estimtes the
vrince risk premium bsed on
few fctors, the most importnt being
the dierence between the expec-
ttions bout booming econom
between n mbiguit-verse inves-
tor nd n investor who exhibits cls-
sicl expected-utilit behviors. Now,
we know how to estimte the ltter
expecttionthts just the CaPM, e-
cient mrkets orthodox tht hs been
tught in business schools for decdes.
How do we estimte the former, the
expecttions of mbiguit-verse inves-
tors? The uthors rel on n existing
model known s Epstein-Zin tht incor-
portes elstic consumption prefer-
ences tht vr over time. M worr is
tht, s the composition of the invest-
ing public chnges, preferences bout
consumption nd mbiguit re likel
to chnge, too. Wht if the economic
ccles of the next 30 ers dont look
nthing like the lst 30 ers? How
will the shift mong Bb Boomers
from equities to bonds ect the equit
nd vrince risk premi? These sorts
of long-term issues become more
importnt when our pricing model
mkes explicit ssumptions bout
investor preferences. In other words,
there is some genuine uncertint sur-
rounding the mbiguit model. EM
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