Archive for April, 2013

Options. In English [Part 2]

I wrote the first installment of this series over two years ago, promising to explain the practical ramifications of the the basics that I’d covered using the tools of the trade. After enough procrastinating, I’ve finally gotten around to doing the second installment.

Questions Answered

Before I begin I wanted to address a number of questions that were emailed to me between my last options article and this posting. If you have any other questions, shoot me an email. justin [dot] braun [at] scaleddynamics [dot] com.

Q: What are some different risk management styles?  Especially ones that would make options more attractive than futures.

Managing risk is ultimately looking at your trading strategy and asking “what can go wrong?”

A popular strategy for day traders is to make sure that they go home flat (not have a position on) every night. Historically, this would limit the amount of money they can lose by avoiding price gaps between sessions. Many exchanges place daily price floors and ceilings on how far a tradeable instrument can move from its opening price (or in some cases, previous day settles) in a day. Further, the less time you have a position on, the less opportunity you have to lose money. High frequency traders take this to the extreme, trying to hedge or even take profit from a trade microseconds after a position is put on. Options are significantly less liquid and with the exception of trading deeps against futures, exiting positions every day would require the trader to give up an unrealistic amount of edge.

If you’re long options, these limits are built into how little the option can decrease in value. Buying a combination of puts and calls will typically yield a long volatility position. With a long volatility position you will lose money in the form of theta decay every day as the time value of the position diminishes, but make money during large price moves or during increases in volatility. The advantage of such trades are that your capital-at-risk is roughly equivalent to the price of the options you purchased, and watching your erosion is a daily expected occurrence.

If you’re short options, time is literally on your side in the sense that you collected a cash premium for something that will diminish in value every day….. or go in the money and cost you a fortune. Writing premium (or selling calls and/or puts) is a very risky  proposition, but it will pay you consistently… until it doesn’t.

Q: How important is it to know the actual math behind the greeks? 

Not at all!! If I were asked to explain the math that goes into any of the models I write about, I’d be immediately exposed as a quack! I can only add, subtract, multiply, and, on a good day, divide. With that said, my customers can attribute millions of dollars of profit to the systems I’ve built. What is important is a qualitative understanding of the meaning behind each greek and how a given action (getting a fill, change in underlying, change in volatility,passing of time, change in interest rates) will change your position and exposure.

Q: How is Implied Volatility calculated?

Most options models use a partial differential equation to calculate their values, meaning that the equations are unidirectional. You can’t get the inputs from the result. Since volatility is an input, you need to take a guess what the volatility is most likely to be, and then search for the correct value by moving inputs up and down until you get the right value. This is very computationally expensive, but not as bad as it sounds. The Newton Rhapson method is the most commonly used way to search for the correct values in an efficient manner.

In practice the better your first guess is, the smaller a net the algorithm has to cast to search for the proper value. You might search for a known volatility of a nearby strike, or a previously known volatility, for example.

Setting up a Trade

From the beginning, the power of options are that they give you significantly more control over how much exposure you wish to obtain, and they allow you to make bets on more than just direction. Unlike futures, fair value is stupid-easy to calculate. You choose an underlying instrument, pick a pricing model, and voila, you have fair-value. None of the nuances of the multitude of models out there matters close to expiry and/or near-the-money. While nothing stops you from having one and trading based on it, an opinion about whether the underlying market will go up or down isn’t necessary.

To that point, say that you have no clue whether the price of gold is going to go up or down, but you do think that the market is a bit too quiet compared to other commodities. You think that regardless of what happens, gold is in for a big change in price, but you’re not sure what direction it’s going to move. The trade: Buy Straddles or Strangles.

A Straddle is the buying of a call and put at the same strike price, and a Strangle is the buying of a call and put at different strike prices. The difference is that the capital at risk of a strangle is a fraction of that of a straddle, and the comparative payout is larger as well.

As of this writing, gold is trading at around 1465. The June 1465 calls and puts are trading around roughly 35 at approximately 21.3% volatility. Let’s plug this into the formula engine inside of SD Gatekeeper and simulate what a straddle trade might look like.

Formula Audit

First let me explain how my formula engine works. Each function outputs the result of a calculation with various arguments. I can either use static values for arguments, or pull directly from an instrument feed. In this example, I am doing a combination of both, pulling the strike price and expiration date directly from the Jun13 1465C instrument, and setting the futures (underlying), interest rate, and volatility manually. Using the same inputs, the following formulas produce the following values:

B76.Price.Call(Future: 1465, Strike: Primary.Strike, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 35.36

B76.Price.Put(Future: 1465, Strike: Primary.Strike, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 35.36

B76.Price.Call(Future: 1470, Strike: Primary.Strike, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 37.97

B76.Price.Put(Future: 1470, Strike: Primary.Strike, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 32.98

(38+33) - (35.4 + 35.4 ) = .2

 

Assuming that you could buy both put and calls at 35.4 (gold options tick in .1) when the futures were at 1465, and assuming that you could sell them at 38 and 33, you’d have locked in a profit of .2 (or 2 price increments) on a $5 price move in the underlying.

Now let’s see what that same move would look like with a Straddle. This time we’ll buy a call and put that are $5 out of the money.

B76.Price.Call(Future: 1465, Strike: 1470, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 32.98

B76.Price.Put(Future: 1465, Strike: 1460, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 32.86

B76.Price.Call(Future: 1470, Strike: 1470, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 35.48

B76.Price.Put(Future: 1470, Strike: 1460, Rate: Rate, Time: Primary.YearsToExpiry, Volatility: Volatility) = 30.56

(35.5+30.6)-(33+32.9) = .2

In both cases, a profit of .2 was locked in however the picture is not so simple. First, the strangle position cost less to purchase (70.8 vs 65.9) so the returns of the straddle are larger. Further, in the example shown I was using a flat volatility of 21.3%. In real life, volatility changes from strike-to-strike. When viewed on a graph, volatility tends to have a specific shape.

VolEdit

The green line in the middle represents where implied volatility is at each strike. Note that the line slopes slightly down to the right (higher strikes). This means that the options will get cheaper as prices increase. In this case, you’ll make more money on a break in the underlying than you would a rally.

In my next installment, we’ll cover how changes in volatility will affect this trade, discuss more strategies, and if I’m feeling super ambitious, we’ll even do some real execution.

Walk for HD – May 19, 2013

While most of this blog has been about self-improvement and making more money, today I want to talk a bit about Huntington’s disease. According to Wikipedia,

Huntington’s disease (HD) is a neurodegenerative genetic disorder that affects muscle coordination and leads to cognitive decline and psychiatric problems. It typically becomes noticeable in mid-adult life. HD is the most common genetic cause of abnormal involuntary writhing movements called chorea, which is why the disease used to be called Huntington’s chorea.

The disease is hereditary. It is not contagious and doesn’t spread due to infection, but rather it is passed down from one generation to the next. The Huntington’s gene is dominant, meaning that if one of your parents has it, you will have a 50/50 chance of being born with it as well.

The following is a MASSIVELY oversimplified explanation of how Huntington’s works: DNA has four kinds of nucleotides that comprise its “code.” They are guanineadeninethymine, and cytosine, represented as letters G,A,C,T. My understanding is that people with Huntington’s disease have too many expressions of GAC in a certain part of their 4th chromosome. That repetition of GAC is more or less an instruction for the body to make a protein that prevents nerve cells from doing their job. These proteins build up in the body over time and people begin to show symptoms as they age.

There is a ton of great research and even the possibility of a new treatment that can “reset the clock” on Huntington’s; but actually getting to the point where it becomes a viable treatment is a ways away. This is worrisome to me because the disease only really affects 30k people in the US. Compared to heart disease, cancer, and other number one health related killers in the US, my worry is that new treatments could get lost in the political red tape required to get drugs approved in this country.

As a result, my firm, Scaled Dynamics, is participating in a fundraiser to promote Huntington’s Disease treatment and research. Scaled Dynamics will match any money that my employees wish to donate from their paychecks. All of the proceeds will go to the Skewes, Vasquez, and Young HD Fundraising Page where they will ultimately go to the HSDA. You can read about the HSDA and their work here.

If you would like to donate, or would like to walk with us, please find this information below:

The Illinois Chapter of the Huntingtons Disease Society of America presents the 9th Annual TEAM HOPE WALK!  Help us to continue funding the mission of the Huntingtons Disease Society of America!  The past 8 Walks have helped raise over $375,000!  NEW THIS YEAR!!!! The Walk has been moved to the Naperville Riverwalk in downtown Naperville, Illinois.  The Riverwalk offers a walker, wheel chair, wagon, and stroller friendly path.  Dogs are very welcome as long as they remain on a leash.  The Riverwalk is WELL shaded.  Please remember to bring enough non-alcoholic drinks for yourself as well as any dogs you bring along.  After the Walk, stick around for our family style hotdog lunch (be sure to bring your lawnchair), games for the kids, and great conversation with friends. The Riverwalk also offers a playground for the young ones that attend as long as their parents are with them.  We will start at the Grand Pavillion at the far west end of the “Beach” parking lot.  We hope to see you there!!  More information can be found on our chapter website at http://www.hdsa.org/il.

Date Sunday, May 19, 2013
Location Naperville ,  Illinois
Contact Dave Hodgson
815-498-6092
spiketdog@softhome.net

 

About the HSDA:

The Huntington’s Disease Society of America is the largest 501(c)(3) non-profit volunteer organization dedicated to improving the lives of everyone affected by Huntington’s Disease. The Society works tirelessly to provide the family services, education, advocacy and research to provide help for today, hope for tomorrow to the more than 30,000 people diagnosed with HD and the 250,000 at-risk in the United States. The Society is comprised of 45 local chapters and affiliates across the country.

Update: Apr 27, 2013: I’ve just been made aware that t-shirts are also available here

How to negotiate a raise

Asking for a raise can be a nerve-wracking experience. Since my professional career began in 2003, I have been successful in applying Moore’s law to my income. For the non-technies, that means that I my income has doubled roughly every 18 months for the past 10 years. A large majority of this time was spent working for someone else, so it follows that I’m pretty good at getting raises. As an employee of a number of firms that you can read about on my LinkedIn profile, I was regularly successful in negotiating raises of 50% or more.
As someone who has been both an employer and employee, I have negotiated both sides of the compensation coin. After explaining some of the techniques that I’ve used to negotiate raises, I’ll give you a sneak peek into the decision making process that I go through when determining whether to grant my employees’ requests for raises.

First you have to understand that asking for a raise comes with an implicit threat that “I will quit if you don’t give me what I want.” No seasoned employer is naive to this and they will do everything in their power to have their cake and eat it too by convincing you to take a sub-satisfactory raise and be happy about it. Further, as a self-respecting employee, you have an obligation to yourself to quit if you do not get what you want. Think that sounds like an impossible situation for both parties? It gets worse. A failed compensation discussion is the death of your career at that firm. If you don’t price yourself high enough, an employer won’t respect the work you do. You’ll find yourself succumbing to increasingly unreasonable demands from an employer after they know they’ve won. I don’t say this to dissuade you from asking for the raise in the first place, but rather to be very careful about the circumstances surrounding when you ask for the raise. Timing is everything.

That saying that “It’s easier to find a job when you already have one,” is the cornerstone of my raise strategy. Every employee places a valuation on themselves. Line employees, especially talented ones who have a track record of producing tend to feel undervalued while middle managers with underlings doing most of their work tend to feel overvalued and insecure in their positions. In either case, most employees valuations of themselves are completely irrelevant since they are only ever worth exactly what another employer is willing to pay them. I think you can see where I’m going here; STEP 1 IS TO GET ANOTHER JOB OFFER! Other guides will tell you to “research what others in your field make,” which will only give you a ballpark of what you might be making if you were someone else and working for another company. You can never be someone else, but you could be working for another company. When you get another offer, you’ve just secured your raise without having to make a single uncomfortable pitch to your boss. If your new job offer comes in at 15% more than what you’re currently making, then you can know with 100% confidence what number your current employer has to beat. What’s more, dusting off your interviewing skills will help to prepare you for the actual raise negotiation.

Step 2 is to build your case. People in Sales, Marketing, or any department that can be considered a profit-center will have an easier time doing this than those who are cost-centers. A profit center is anyone in a role that helps to bring new money into the firm. They’re judged by an employer purely in terms of return on investment. If you’re a profit center, your returns should be the main focus of your pitch. This gets trickier for employees who develop product, provide support, or even worse, and are on the operations side of things. I’ve molded my career by staying as close to the money, but it’s not impossible to ask for a raise as a cost center if the circumstances are right. People who work in financial risk management and compliance in this post Dodd-Frank world are in demand, for example. When recruiters start calling you, it’s time to build a case that you need to be “brought to a level consistent with the rest of the market.”

NEVER threaten to go find another job. That threat is already is implicit in the compensation discussion to start out with, but bringing it out into the open can make an employer turn openly hostile in a hurry. You also need to be careful to never compare yourself to what coworkers are making. Everyone likes to think that they run a meritocracy, so bringing that up might quickly expose you to the risk of being told that “you’d be paid like your coworkers if you performed like them.” Lastly, don’t pad your requests. Asking for a $15,000 raise hoping to get $10,000 will often make the employer balk at your request. I’ve said things in the past like “I’m not asking for $10k hoping to get $8K, I’m asking for $10k because $10k is what I need to be happy here.”
Now that we’ve covered what to do as an Employee, I’m going to give you a sneak peek of some of the things that go on in my head as an employer. First I would like to explain how things go in my company. I like to take a proactive approach and have compensation discussions with my employees at the end of every calendar year. I do this because losing a key employee (or even having him job hunting) because he doesn’t have the stones to approach me with a raise proposal is often more disruptive than having to pony up once a year. So with that said, I do my best to answer a few key questions whenever a compensation discussion with an employee takes place. Namely:
How much do I like this employee? For employees who are a lot to manage, upset corporate culture, or are otherwise difficult to deal with, I view this raise conversation as an opportunity to drive out someone that might have been problematic to begin with. This might be the opportunity to let them talk themselves into quitting and saving me the expense of firing them.
What is my total cost to replace this employee? I break this down by answering 3 more questions:
How long will it take me to find a replacement for them? Downtime is expensive.
After I find a replacement, how long will it take me to get the new hire up to the previous employee’s level of proficiency? Paying someone to learn is expensive.
How much will the replacement employee cost me? If the current employee is performing well and asking me to adjust their salary to something that is commensurate with the market, I will give them the raise they asked for and thank my lucky stars that I got away with paying them so little for as long as I did. I’ll usually hesitate heavily, and say something to the effect of “Well, that’s a lot more than what I really had in mind but you’ve been kicking ass lately and I want to see more of that.” This makes them feel like they won a huge victory and I’ll get at least 3-5 months of even higher performance out of them.
How big of a raise is this person asking for? I’m going to use whatever this number comes out to, compare it to my “cost-to-replace,” and then use every negotiation tactic in my playbook to talk their request down. And guess what, I’m better at it than 95% of unprepared employees unless they bring real leverage to the table.
I have a few tactics in my playbook that leave the employee coming out feeling like a winner but often agreeing to marginal raises. I’m good at mental math, so with line employees and non-engineers I’ll break down compensation package using unfair comparisons. People aren’t very good at understanding the effect of an annual compensation change on their lives but it’s very easy on a monthly basis. Rather than offering someone a $3,000 raise, I’ll offer them a raise of $250/month, for example.
Another favorite of mine is back loading compensation into bonuses. I’ll use arguments like “We want team players in this company, not just people looking to make a buck. If the team does well, you’ll do well, so how about I give you the exact dollar amount of raise that you’re looking for, but 80% of that raise is going into your bonus potential.” It’s great for me from a cashflow standpoint and I only really have to pay out if my firm does well. Win/Win. If the firm is doing well, any smart employer will spread the wealth around because inconsistent rewards will make an employee work WAY harder during bad times.