Adam Warner is the author of Options Volatility Trading: Strategies for Profiting from Market Swings, released in October 2009 from McGraw Hill. Adam has guest-written Barrons Striking Price, and regularly contributed to several sites over the last 7 years, including Street Insight, Trading Markets, and Minyanville. He is also a co-founder of Expiring Monthly magazine. Adam writes a popular “Daily Options report” blog.
When not writing, Adam is a proprietary option trader with Addormar Co, Inc. Previously Adam traded as a member of the American Stock Exchange from 1988-2001.
I asked many of the questions on behalf of OP readers. In the interview text below “I” and “OptionPundit” are interchangeable for the purpose of conversation with Adam.
OptionPundit: Adam, It is a pleasure to have you with us.
Adam: Thank you.
OptionPundit: Adam, is there a KEY MESSAGE you would like to share with the readers before we begin our discussion.
Adam: Markets have dramatically changed during the past 10 years. You will find sideways actions for a while when nothing is happening and everything seems calm; suddenly violent volatile moves starts. VIX Trading in teens goes past 20, 30 or 40. We are more globally connected now and what happens in Asia overnight, at times, governs how US markets will react to. There is much more automation, high frequency traders and then there are weekly options. Bid/ask spreads have moved into pennies. It is much more difficult for retail traders to survive these days as opposed to few years ago.
OptionPundit: What do you think are the key success drivers for making money “consistently” via trading options?
Adam: I wish I knew, I’ve done this for 20+ years, and there’s really no one winning strategy. Net-selling options will produce a better winning percentage than net buying, but you will have to sidestep some major accidents. The volatility explosion of the past few weeks is Exhibit A.
OptionPundit: What kind of trading strategies would Adam recommend as most suited for these (now and say the next 6 months) volatile times?
Adam: I would stick to spreads, perhaps selling put spreads if you’re bullish (or conversely call spreads when you’re bearish). Spreads are very capital efficient, and they define your maximum risk. If you have no strong directional opinion, but just want to sell volatility, Iron Condors work well.
OptionPundit: If Adam were to trade directionally, which technical indicators would he use? Under what circumstances will Adam take directional trades?
Adam: It is easier to pick direction on Volatility (IV) than on stocks. In options world, I like watching VIX vs. its 10 Day Moving Average, as well as against Bollinger Bands. VIX tends to mean revert, especially when it breaks out to the upside. And since it goes inverse to the market, it can give a decent timing signal for bullish trades. You really want extremes though, like 20% above the MA, or a clear break above the BBand. And keep in mind, like any indicator, this can go WAY past the station. Again, as in the past week, VIX actually peaked at a record 74% above the 10 day SM).
After you formulate an opinion on direction, it is better to scale-in/scale out vs. all-in-one investment.
OptionPundit: There are many volatility related indicators, could Adam pls suggest a few that one can use effectively?
Adam: I guess my last answer works for this too. I can’t emphasize enough that nothing stops a market in free-fall. By and large, fading an overbought VIX works, but clearly not always.
OptionPundit: There have been numerous discussion on Historical Volatility and Implied Volatility. Could Adam pls suggest how best to use these two measures?
Adam: Historical volatility tells you what the underlying has done in the recent past. So it provides a good guideline on how to price options going forward, that is, the implied volatility. I would only use a very short-dated HV. I like 10 day. Its noisy, but gives a good indication how the stock is moving right now. Important to remember there’s no *arb* between HV and IV, a stock may have moved a ton in the past, but options can correctly price in that volatility will decline going forward. Case in point, 10 day HV in SPX is currently over 60, whereas IV is in the low 30’s. That doesn’t in any way mean options are cheap.
OptionPundit: Under what market conditions buying strangle on volatility would be a good trade.
Adam: Volatility spikes can strike at any time. Strangles mostly don’t work, but you do get occasional windfalls that can pay for an awful lot of bad strangles. I don’t believe in bottom fishing volatility, I’d rather buy into strength. Remember that when you buy a strangle, you’re really betting on the historical volatility of the underlying, so its more about what the underlying does than what implied volatility does.
OptionPundit: Currently I’m a bit involved in excel_scanning volatility arbitrage situation (contango related). I think that some word from Adam on the VIX contango will be interesting. The question is “is there a statistical edge in exploiting some divergences between the VIX Futures value in some particular occasions”? (More on this)
Adam: Good question, I honestly am curious on that, I don’t know the answer. We’re in backwardation now. Sort of, its pretty flat beyond the first couple cycles. And all futures are cheaper than VIX, although that’s narrowing. Not saying VIX futures or the tracking ETN’s like VXX and VXZ are outright buys per se, but on a relative basis, I’d sooner buy those now than actual options at this volatility.
OptionPundit: I started implementing the earnings strangles strategy this earnings cycle. The idea is to buy a strangle 10-14 days before earnings and sell before the earnings. The increase in IV should compensate the negative theta so even if the stock doesn’t move the trade should be around breakeven or slightly profitable, worst case the loss should be limited to 15-20%. If the stock moves, the gains can be substantial. My question is why this strategy is relatively not widely used. It seems to me like a win-win situation. Of course during extreme volatility periods like now it works even better, but even during calm times it should produce nice gains with short holding periods and limited risk.
Adam: Well, you’re correctly gaming that your options will hold their value ahead of news, So you do get a little window there to own some options gamma with not much time decay. I suppose you’d lose a bit in a general volatility decline, but it sounds like a solid strategy overall.
OptionPundit: The strategy from which the xvix product is based has performed poorly since ETN inception. Granted returns in 2010 were “insanely good”(particularly risk adjusted), can you provide insight as to why mid-term (vxz) leg of this trade has unwound so much in recent history? is it because the market perceived us no longer being “systemically risky” which would bring an end to former volatility regime? if so are there any hints in term structure or otherwise (macro or technical) that can give us a wink as to when it is a potentially favourable environment to be in(out) such a product?
Adam: Yeah, I think that had to do more with the timing of the introduction than anything else. It came to market after VXX had gotten perpetually slammed thanks to constantly having to roll up into Contango, while VXZ had held up better. But as 2008 faded in memory, there was less expectation that VIX would perk back up again *sometime*. So VXZ started to underperform. Setting aside that we’re still unwinding the recent VIX pop, it seems more like the volatility curve is in equilibrium than anything else. There shouldn’t be enormous premium for VIX futures out in time in a *normal* low 20’s, high teens VIX world.
OptionPundit: I have gravitated towards using volatility based products to hedge equity exposure as opposed to traditional index puts (which are often priced dear). I recently did very well with a call -1/+2 backspread on vix eurostyle options, but the liquidity of the vxx, vxz products is tempting. Do you see an edge/advantage to playing such hedging strategies on the ETN options or VIX options? What about hedging using vxx/vxz underlyings directly using concepts like Barclay’s vector strategy?
Adam: Its funny, I’m a bit of a new convert to using VXX and/or VXZ off the long side as a hedge. I like those better than VIX products, but not sure its any more than personaI pe think preference. VIX options cash settle, which I don’t love. I think with VXX, you have to look at it as you would a simple put. It will decay in value over time if the VIX curve is in contango, so you have to adjust your sizing accordingly. The backspreads you mention can get pricy, but can also explode like they did recently, so it’s a tradeoff.
OptionPundit: What software options are out there for those of us who don’t have access to bloomberg spread charts. I am so jealous of these, snap shots. what is out there that can do this and allow us to chart prem/discount in term structure?
Adam: I don’t have BBerg either, I don’t chart the futures though, so I’m not the best example. I just use the VIX options board on TOS. All that being said, I’m not a big believer in charting anything VIX to begin with. I mean I look at it for moving averages and all, as I mentioned above, but its dangerous to look at a vix chart like you would a stock chart. It’s a statistic, not a stock that’s bought and sold.
OptionPundit: What do you think is the best way for an newbie to start trading options?
Adam: Should you choose direction, play it via spreads especially the vertical spreads. Those are versatile and has defined risk/reward profile. You already know how much are you risking to make what. Don’t get carried away with the leverage aspect too much. A $1000 investment is still a $1000 investment. Think of it in terms of deltas that you can either make or lose.
OptionPundit: Thank you for your time Adam. On behalf of all the option traders, I sincerely appreciate your sharing. Hopefully the insights you shared will help retail option traders in building their own toolbox to deal with current state of markets and achieve better winning consistency. I look forward to future conversations.
Adam: It was pleasure to talking to you. I also look forward to future opportunities.
Dear readers, I hope you enjoyed the interview and found some insights that might help in your trading. If you have any feedback, comments, suggest, follow-up questions, pls post it here in the comments section. I shall follow-up with Adam to respond those.
Profitable Trading, OP