Well, we are back in the market and things have been looking more positive. I am writing this after trading on Thursday, and I saw an example of volatility crush so I thought it would be a good thing to have a look at, along with time decay.
I spent a frustrating hour on Schwab SSE trying to get the option charts, which I knew were hard to find. I had thrown out my cheat sheet in my most recent office clear-out, thinking ‘oh, I’ll easily remember that’. But I didn’t, and support had no idea, but I poked around and eventually found it. For those of you who trade through Schwab in case you don’t know here’s the path: Launch SSE / Launch Tools / SS Central /account positions /choose chart icon / detach.
We know that DITM options have little time value, and the ITM strategy looks for options with around 1% time value and 99% intrinsic value. At expiry, no options have any time value left (because there is no time left) so the most time value we can lose on one of these DITM options is 1%. However, that’s not the case for OTM options.
It is November options expiry on Friday, so I am going to look at 2 options that expire tomorrow: a 445 call and a 455 call.
The 445 has $1.54 intrinsic value (How? Current price of $446.54 – strike $445). Here is its chart over the last 3 months, with volume plotted below it.
OK, what do we notice? Two things:
(1) The price dropped dramatically, from $18, to $0.13 before recovering a bit to $5.55.
(2) The volume has increased as time has gone on.
If I took this snapshot after Friday’s trading you would see a massive increase in volume, and if I put it on an intraday timeframe most of it would be in the last hour, as traders frantically try to buy and dump before closing.
This was an option that could quite possibly expire in the money, so lets look at another that is very unlikely to: the 460 option.
What do we notice here? It has dropped from $$8.50 to $0.01 and hasn’t recovered. Instead of the volume increasing it has dropped away as traders give up on it ever being in the money, apart from Wednesday then everyone apparently dumped it.
Why am I showing you this when it isn’t part of the ITM strategy? Because you may want to play with a small part of your account (I do, it’s fun) just be aware that it is totally possible to lose big time.
There is another annoying thing about OTM options. they are subject to volatility crush. This refers to the reduction in the price of an option because of a reduction in the implied volatility. Implied volatility increases when the market expectations are for future price fluctuations of the underlying. A drop in implied volatility means that the market is expecting things to calm down a bit, and the price to become more stable.
The VIX (volatility index) has dropped to just over 14 which means that we are in a time of very low volatility. This has an effect on option prices, making them cheaper – but not all options are affected equally. For comparison, here is the SPY chart for the last 3 months. You can see that after a gap up on Tuesday it has been relatively flat. But the option prices are interesting.
Here is a snapshot, taken after Thursday’s trading, of some positions in one of my accounts. You can see that SPY went up, not much but 0.12%.
Two of the options went up. The Mar 2023 230 strike went up 0.25% and the Mar 2023 440 strike went up 0.75%. How to explain the disparity? Well, the 230 strike is leveraged at 100% so went up double SPY as expected (there is no point showing a graph as it is very thinly traded). The 440 strike went up 0.75%, significantly more. Why?
Here is the graph of SPY for the last 3 months:
And here is the graph of the 440 call for the same period:
You can see that the pattern is essentially the same, but the outcome is far better at 0.75%. As it is a near the money call it has a higher percentage of time value than the DITM call and so is more affected.
And lastly, the 460 call:
What is annoying about this option pricing is that the underlying SPY went UP, but the option went DOWN. Volatility crush in action.
Backtesting the QQQ
I have been backtesting QQQ using the ITM strategy – and the results are not encouraging. I am trying to figure out exactly why, and I suspect it is to do with the volatility of QQQ being higher. Drawdowns (losses) early in its life contribute to the underperformance. QQQ was started just before the ‘Tech Wreck’ in 2000, and then suffered very badly during the GFC.
Here is the relative performance of SPY and QQQ this century:
The 100% leveraged account beats the market but only by 29%, which is not exactly breathtaking. I will keep working at it, although I have so many strategies I am testing that I am starting to get lost. I need to take a break for a couple of days then regroup
I haven’t forgotten this, but I haven’t been able to force myself to do this for the last few weeks. The account is still open so I will have another look at it . . . sometime!
To The Markets:
Well, we have been back in the market for a week now – and a funny old week it has been. After a huge gap up on Tuesday, the market has been dithering, unable to make up its mind about going north again. The good news is that it is showing no signs of retracing and closing the gap. For now, at least. So, let’s look at the charts.
The downtrend line has been broken – that happened on Tuesday, and trading has been above it for 4 days now so that is confirmed. What is unusual is the gap up, followed by a positive (although not long) candle, then followed by 3 classic dojis. Doji is a Japanese word meaning ‘the same’ or ‘unchanged’, and refers to candlestick with a very small body, meaning the open and close prices are very close.
Dojis suggest indecision in the market as there is a balance between buyers and sellers, and can occur during periods of consolidation. They do not mean anything in themselves, but can be significant as part of a larger pattern. In this case we have three in a row, so hopefully we are looking at consolidation before the uptrend continues.
Other things to note: we have broken resistance at around 444, so this may turn into support. We are approaching the high of late July ($457.79) which was the highest point since the start of the bear in January 2022.
It has been a long 23 months. What a time to publish a book on a bull market! 🙄
SPY Chart in perspective
But let’s keep things in perspective. It is a good idea from time to time to see the longer term trends. Here’s what has been happening since Covid:
And here’s what has been happening since the GFC:
And here’s what has been happening for the last 123 years:
Not particularly helpful? Let’s put it on a logarithmic chart:
I’ve marked some of the important dates, and put a trend line on since the depths of the depression nearly 100 years ago. Yes, we are above the long term trend – but then we have been for the last 40 years.
Why look at ancient history? Because, for me, it helps me gain perspective rather than get too caught up in what is happening right now. Hope it helps you too.
Much the same as SPY, with the same gap up and then the dojis. As we never got a death cross in SPYG, we are still in the market and have been since March. SPYG is now approaching its previous high of $62.89, and is up 14% since entry, so at 100% leverage you should be up around 29%.
The last week has had the same pattern as SPY and SPYG. QQQ is butting up against its post-2022 bear high and is approaching its previous post-covid high of 400.
The VIX continues to drop.
I will be publishing another short book, the 1 – 2 hour series, this one is about reading stock charts. It will probably be rather basic for many of you, but you may know someone just starting out that would find it helpful.
It is all written, now I just have to pull it into the various formats, which is time consuming and frustrating. I find it is actually quicker to do it myself, rather than have someone who doesn’t know the subject material do it. I have an ulterior motive for announcing it – once I have said that it is going to be available then I have to actually do it! It’s a great motivator.
The week ahead . .
The futures are down slightly, but it is almost 12 hours to market open so it doesn’t really mean anything at this stage. Lets hope that the market gets out of consolidation and starts going up again!
Anyone work out why I chose the image at the top of this post?
Questions & Comments
As always, happy to answer questions and receive comments (just be kind!)