Bell Curve Blogs

Bell Curve Blogs
  • How is the Option Market Lately?

    Market Commentary The fund performance is flat (or up 0.6%, if adjusted by the mismark by the end of month), while the S&P 500 continued its slow rally, up 1.2% (it made a historical high on May 21). For the year, the fund is up 13% before fees, while the SPX is up 2.4%. The market rallied in the face of “Sell in May...

    How is the Option Market Lately?

    Market Commentary
    The fund performance is flat (or up 0.6%, if adjusted by the mismark by the end of month), while the S&P 500 continued its slow rally, up 1.2% (it made a historical high on May 21). For the year, the fund is up 13% before fees, while the SPX is up 2.4%. The market rallied in the face of “Sell in May” skeptics. While the VIX had a wide range (11.8 to 16.4) this month, the tradable VXX dropped below 20 into teens, as we predicted last month.

    Under the surface of such calmness, there were several major macro themes, some of which may turn out to be historical. First, there were violent movements in the long-term US Treasury market. 5-Day realized vol of TLT was at 30 in mid-May, well above SP’s! Such movements (mostly down) were corresponding to the narratives of QE ending, nevertheless, such down movement in treasury (thus rate jump) occurred at the time while the probability of the Fed raising rates in middle of the year receded. Thus we will simply recognize the fact that economic narratives rarely translate directly into daily movement. With tongue-incheek, may I suggest that we should replace government treasury, “risk-free” asset in option valuation by the more “stable” US equity index? The second major event is the rapid ascent of the Chinese stock market, which is up over 40% YTD. The ETF FXI, which is more associated with Chinese big caps, especially financial stocks listed in Hong Kong, rallied to recent multi-year highs, with implied volatility at 28, not historical high but quite standout in this low vol environment. The characteristics of FXI and other Chinese stocks were similar to other historical bubble market: very flat skew, with positive correlation in stock and vol direction. The third theme is the M&A activities.

    The $37 billion takeover of Broadcom by Singapore tech company Avago is the biggest ever tech deal (not counting AOL-Timer Warner $165 billion merger at the peak of Internet bubble year 2000). There are a flurry of deals in semiconductor space, such as almost certain deal of Intel take-over of Altera ($15 billion), and the perpetual rumor mill of SanDisk being taken over by someone. Is this a sign of valuation peaking? On the last trading day of the month, the Q1 GDP growth was revised from +0.2% to -0.7%. Though not a surprise, this is obviously a concern of whether this is a one-off reading or the beginning of a turn. However, GDP reading cycle is much delayed and usually takes three readings for each quarter. Thus these may not have the same size of impact on equity market vol as the monthly job number. All of these interesting market occurrences happened in May before we even comment on the elephant in the room: Greece, which is on the brink of sovereign default, or “Grexit”.

  • A Brief History of Options

    Options are contracts with conditional obligations. I will exam here the origins of these two concepts in human civilization, and put the option trading in historical perspective. The earliest written record of contracts that entailed some insurance was the famous Code of Hammurabi around 1750 BC, developed by Babyl...

    Options are contracts with conditional obligations. I will exam here the origins of these two concepts in human civilization, and put the option trading in historical perspective.

    The earliest written record of contracts that entailed some insurance was the famous Code of Hammurabi around 1750 BC, developed by Babylonians and used in early Mediterranean shipping – a merchants received a loan to fund the shipment would pay additional premium in exchange for the lender’s guarantee to cancel the loan, should the shipment be stolen or lost at sea. This can be considered as earliest form of a put option.

    The other most quoted example related to options is of Thales in Ancient Greek. According to Aristotle, Thales of Miletus (c. 600 BC, who was the first mathematician to use deductive method for geometry and famed for the Thales Theorems), predicted that the coming season’s olive harvest would be larger than usual, thus during off-season, he acquired the right to use some olive presses the following spring. When spring came and the harvest was larger as he expected, he exercised his options and rented the presses out at a much higher price than he paid for his option, thus made a nice profit to prove a point that a philosopher could actually use his theory to make money. This can be considered as the earliest form of a call option.

    During the peak of Dutch Tulipmania in 1630s, options were widely used and might contribute to the mania itself as well as the misunderstanding of the mania. For example, in the popular book “Extraordinary Popular Delusions and the Madness of Crowd” by Charles Mackay, Mackay might be confused about the premium of an option and the strike price of an option, and made dramatic claims about the mania that still form the public impression of the first major financial bubble in history.

    Option trading started in London in 1700-1733, and was made illegal from 1733-1860, a ban of more than a century due to the public fear of speculation (result of the South Sea Bubble, which Isaac Newton was sucked in, peaked at 1720s).

    Russell Sage, a financier who was a friend of the “robber baron” Jay Gould, introduced options to USA in 1872, likely copied the model from London. The options traded at the times were all so-called OTC (“over-the-counter”) contracts, which the terms were non-standard and negotiated between two parties.

    In the first decade of 1900s there were two most important discoveries in option theory: one was the application of “random walk” or “Brownian Motions” theory in option pricing, by the French mathematician Louis Bachelier. Such method, which revealed the statistical nature of options, or “Volatility”, became the foundation of the modern option pricing theory, and the subsequent the Black-Scholes model. The second important discovery was the application of call-put parity by multiple option traders and scholars in first few years of 1900s (even though Russell Sage already knew how to use it to create synthetic loan). The call-put parity links option to futures contracts, but more importantly, it dispelled the myth that calls and puts are directly linked to bull bear sentiment.

    Until the opening of Chicago Board of Option Exchange (CBOE) in 1973, options are trading on the side market with non-standard or OTC contracts, and were usually associated with shady dealing. The advance of CBOE (as part of CBOT) brought standardized contracts (“Exchange Listed Options”), introduced transparency and volume into the derivative market. In some sense, 1973 can be considered as the dawn of modern financials.

    Coincidentally, in the same year, Fischer Black and Myron Scholes published the Black-Scholes model for option pricing. Undoubtedly, that is the most important milestones not just in options but also in modern financial theory. It ushered in an era of pricing financial derivatives through a framework of stochastic process (that traced its root to Bachelier). Such modeling methodology in returns also brought about the flourish of derivative business on Wall Street in the subsequent decades. In 1997, the Nobel Prize in Economics was awarded to Scholes and Robert Merton.

    Though call-put parity was known in early 1900s, public generally still averted to puts and even considered it as unpatriotic. CBOE only introduced put options in 1977, four years after the exchange was opened. Even when put options were already traded, the aversion to puts continued, leading to the so-called “Portfolio Insurance” in the 1980s, which was basically a trading program to construct market index puts by systematically selling equities. Such folly was the main origin of 1987 “Black Monday”, the biggest one-day percentage stock market crash in history.

    When CBOE first opened on April 26, 1973, it traded 911 contracts. Since then, option trading volume has been steadily growing. Today, each single day the equity option volume is around 15 million contracts.

    The opening of ISE (International Securities Exchange) Option Exchange in 2000 brought the electronic trading to options. In the subsequent years, we see 3 major trends: 1. All traditional exchanges started bringing electronic execution to the mix, while there are several new option exchanges like BOX, MIAX, emerged to serve electronic trading only; 2. As in stock, bid-offer spreads continue to shrink; 3. More standardized exchange traded options are now available, especially the weekly options. In 2000, there are about 200,000 distinct listed options available. Currently there are more than 600,000.

    Volatility strategy probably has its root from the days when Black-Scholes formulas was first published. The collapse of Long Term Capital Management (LTCM), which Scholes and Merton were involved, was in part due to its short 400 million Vega volatility book. The volatility strategy was actually more well developed in the market making business (rather than hedge fund firms like LTCM), such as O’Conner & Associates (acquired by Swiss Bank in 1989), Hull Trading (acquired by Goldman Sachs in 1999), etc.

    The most well-known index related to volatility is VIX, which is simply a selected average of implied volatilities of near term SPX near the money options. The index was first proposed in 1989. CBOE launched the current version of VIX in January 1993. The calculation was back filled to early 80s using SPX options. The highest spikes in VIX were 150 in 1987 Crash, and 80 during the 2008 financial crisis. The interpretation and criticism of VIX are numerous, but after all it is still the most popular index that is associated with volatility.

    Although options have a long history tracing back to the dawn of human civilization, the modern option products like the exchange listed options have a relative short history, and in my view, they are the most successful innovation of modern financials. Consider this: the most active traded equity options today are the SPY options, which take up 15-20% of total equity option volume. SPY options came only into existence in January 2005.

    August 13, 2014
    Derek Wang, CEO, Bell Curve Capital LP. dwang at bellcurvecapital.com

  • Low Volatility Dilemma

    Recently “low vol” becomes an obsession for every market observer or participant, whether he is a vol trader or not. It even catches the attention of the financial news media. Low vol, not surprisingly, is the result of the recent amazing bull market driven by the Fed’s easy money policy. The concern of “low ...

    Recently “low vol” becomes an obsession for every market observer or participant, whether he is a vol trader or not. It even catches the attention of the financial news media. Low vol, not surprisingly, is the result of the recent amazing bull market driven by the Fed’s easy money policy. The concern of “low vol” is not about the volatility itself, but more on the worry that such low vol portents a reversal of the market. For us, the obvious question is, as vol traders, can we still be profitable in this low vol environment?

    First of all, this is not the lowest vol environment we have ever seen – we saw sub-10 VIX in January 2007, right at the beginning of the subprime crisis, while VIX around 10 or below was the norm in the 90s – Currently VIX is around 11-12 in the recent month (touching 10.61 in 6/18). On the other hand, the realized vol of SPY drops to 6.5 for weekly or monthly.

    There are 2 common beliefs about volatility: 1) Implied vol tends to converge with realized vol; 2) Implied vol tends to mean-revert. In the first part, VIX is still too high if it is relative to realized vol, while in the second, VIX is low from historical perspective. In other words, the current “low vol” is not really extreme or surprising; its rationale can be justified in either way.

    For volatility strategy, prolonged low vol environment can be opportunities – the most obvious one is you can cheaply buy into convexity — with some potential pitfalls: 1) believing too much in mean-reversion of implied vol may end up enticing the trader to be too long in vol, which can be painful even when the implied vol holds, but stock movements not realizing (which is typically the case in most environments, high or low vol); 2) If focusing too much on the low realized vol and end-up shorting too much Vega believing implied vol will converge to realized vol, the risk is obvious: a spike in vol, or a long period of divergence of implied vol and realized vol can cause damaging mark-to-market loss in the portfolio.

    Nevertheless, we weather this low vol environment pretty well — every vol trader should take this as a required course: one needs to experience both the high vol and low vol environment to mature. Here are several areas in which we thrive:

    1) Trade the relativity. While most people fixate on VIX and S&P vol, in the single name space, there is still much divergence in vol, not all of which are low. There are still tremendous opportunities on the relative vol on the vol surface (intra-name), or among single names (inter-name). For example, though VIX has a very low reading, it represents only the very short term vol. On the SPY vol surface, we still see a lot of long/short opportunities on the term structure (Currently SPY is at the steepest term structure in recent years), skew and vol spreads capturing expected macro event. There are much more similar vol surface opportunities in active single names like AAPL, FB, TSLA, NFLX, etc.

    2) Controlling the decay. One of the pitfalls of low vol is that it entices the trader to hold onto too much short term options, where Theta overtaking Vega. An extended period of low realized vol can cause frustrating loss from factor that traders cannot control (time). This requires an active balancing management of decay, while understand that low vol can give us huge leverage.

    3) Be nimble, trade actively and be willing to take in small profits while keeping the portfolio relatively light in Vega and Theta risk. Low vol can cause traders to speculate too much either on the emergence of big macro events, or be lulled into complacency. Either way can cause positions to build up too much.

    Two observations from a vol trader who has been through some different faces of the market: First, low vol is actually the norm (while high vol period cannot sustain for a long period of time). Secondly, vol always spikes, except you don’t know when, so be prepared for spikes, but not to position waiting for them.

    So low vol is really nothing to complain about. It’s an opportunity. Just need to trade more and focus on the relativity.

    July 01, 2014
    Derek Wang, CEO, Bell Curve Capital LP – dwang at bellcurvecapital.com