OptionPundit Interview: Author and Investor Jeff Augen

Jeff Augen, currently a private investor and writer, has spent more than a decade building a unique intellectual property portfolio of algorithms and software for technical analysis of derivatives prices. His work includes more than one million lines of computer code reflecting powerful new strategies for trading equity, index, and futures options.  He is author of The Volatility Edge in Options Trading, The Option Trader’s Workbook, Trading Options at Expirations, Day Trading Options, and Bioinformatics in the Post-Genomic Era (Addison-Wesley, 2004). Much of his current work on options pricing is built on algorithms for predicting molecular structures that he developed as a graduate student. Read more about Jeff here; you may also want to read read my review of his earlier book “The Volatility Edge in Options Trading“.

OptionPundit: Jeff, It is a pleasure to have you with us.

Jeff Augen: Thank you.

OptionPundit: Jeff, is there a KEY MESSAGE you would like to share with the readers before we begin our discussion.

Jeff Aguen:  Before 2007/08 financial crisis, markets were stable. Volatility was low, markets were rallying. There were hardly any “flash crashes” and terrorist attacks were the only major uncertainty. However, since 2008 market structures have changed. Government involvement, inter connectivity of global markets and evolution of HFTs all have now changed the way markets react to news. Individuals who limit themselves to using traditional off-the-shelf indicators will always lose money to sophisticated traders armed with more powerful tools. The days of buying and selling stocks when moving averages cross or an oscillator reaches one side of a channel are gone. Moreover, investors who fool themselves into believing that they can exploit combinations of these indicators are making a huge mistake. Times have changed.

Now program trading accounts for almost 80% of the trades. Super computers are being used and accordingly character of the trades has also changed. An example of how markets have changed is the intraday volatility; since 1990 S&P has experienced intraday High-Low transitions > 8% only 14times, 13 of which occurred in last 2 years. Today’s sophisticated investors tend to focus their attention on analysing subtle statistical distortions in volatility and identifying anomalies in derivative prices.

OptionPundit: Jeff, as market structure has changed, can the retail trader still trade profitably? What would he need to stay in the game?

Jeff Augen: The old way of using various indicators e.g. Momentum, stochastic, MACD is gone. He needs to realize that HFT’s /super computers will nullify any trends etc. by the time it is even visible to a trader on the charts. Retail trader need to understand the followings-

• Don’t compete with HFTs. You can’t win against them.
• It is incredibly important to know why market is doing what it is doing. Example Japanese Tsunami’s impact on USD/JPY and subsequent rise of US equities. Fed’s announcement of QE2 and subsequent rally in the markets.
• There is always a place for “human intelligence”. Use your own analysis and trade where there are subtle statistical advantage e.g. Underprice/ Over price volatility
• Move-up/ educate yourself to trade complexities e.g. Volatility arbitrage

OptionPundit: What do you think are the key success drivers for making money “consistently” via trading options?

Jeff Augen: Here is what I think will make a good trader-

• Trade what you understand thoroughly
• Understand price behaviors
• Follow underlying that you understand
• Build upon what you already know
• If you can’t rationalize it, don’t trade it
• Human intelligence hasn’t been superseded by computers. Stay “In-touch” and continuously improve your observation

OptionPundit: We know your opinion about technical analysis through the book titled “Trading realities”. How can one make good use of technical analysis while trading options?

Jeff Augen: Individuals who limit themselves to using traditional off-the-shelf indicators will always lose money to sophisticated traders armed with more powerful tools. The days of buying and selling stocks when moving averages cross or an oscillator reaches one side of a channel are gone. Moreover, investors who fool themselves into believing that they can exploit combinations of these indicators are making a huge mistake. Times have changed.

If you think that market is in trend, just plot the data and run a regression analysis to find R-Square. If the r-square value is not significant, then you can’t say market is trending. If you do want to use traditional indicators, use it in combination with relevant price spike/ volatility anomaly in different time frames.

Question from OP reader: Could Jeff show how to write the code in Excel, Tradestation or TOS for his 1 min standard deviation price indicator from his trading options at expiration book?

Jeff Augen: Here is the code-

Inputs:

SpikeWindow(30),
ColorThreshold(.25),
SpikeFilter(4);

Variables:
OneStdDev(0),
Spike(0);

OneStdDev = StandardDev(Log(C[1]/C[2]), SpikeWindow, 2 )*C[1];
Spike = (C-C[1])/OneStdDev;

Switch (Spike) begin

Case Is > ColorThreshold:
Plot1 (Spike,”Chng”,green);

Case Is <-1*ColorThreshold:
Plot1 (Spike,”Chng”,red);

default:
Plot1 (Spike,”Chng”,white);

end;

OptionPundit: You mentioned in “Trading Realities” that traditional technical analysis has no relevance in today’s market, are there new indicators that can help in evaluating market direction?

Jeff Augen: A much more relevant indicator is the ratio between VIX and the true historic volatility of the market (VIX/true). This ratio came handy in early April 2010 when VIX had fallen as low as 17, but the VIX-to-true ratio peaked above 2.5. The market fell sharply correcting 13% in eight weeks. The market stabilized, and the decline ended when the ratio fell below 1.

In February 2009 with VIX hovering above 50, the market entered a sustained rally—exactly opposite the expectations of most investors who interpret a high VIX as a signal of instability. During this timeframe, however, true volatility remained relatively high peaking above 40%. Readers might want to read my article “Time for a New Indicator: Option Price Variance” in SFO Magazine.

(If you are not an OPNewsletter member and would like to sign-up, pls click here to sign-up for the waitlist as OPNewsletter subscription is open via invitation only).

Here are more questions that many OPN members sent to me. I asked these questions on those member’s behalf.

OPReader: For the strategies you describe in “Trading Options at Expiration”, do you use market orders to ensure a timely fill, especially when closing out trades right at the end of the day or to avoid a loss? Do you consider retail platforms like think or swim adequate for this type of trading, or is there a more specialized platform you can recommend?

Jeff Augen: I always place orders at the midpoint. If they don’t execute then I lose the trade. I would estimate that 90% of the time they execute. However, I never use market orders. Also I avoid “intelligent routing” because many brokers are paid for order flow. So I usually specify ISE or CBOE.

OPReader: For the 1:3 ratios described in ‘trading options at expiration’, the required margin tends to be prohibitive. Would simply selling OTM call credit spreads be a reasonable alternative? How about adding calls to every 3 or 4 of these spreads to mimic the ratio?

Jeff Augen: There are many ways to accomplish the same thing as 1:3 ratio. However, a credit spread is not mathematically identical to a 1:3 ratio. For very little money you can purchase options at the next strike and eliminate the large collateral requirement. On expiration day these options are often $0.05.

OPReader: For the strategy described in ‘Day Trading Options‘ of buying straddles for stocks that have a high frequency of 1.5 standard deviation moves, and holding them for 1 night, exactly when and how frequently would one buy these straddles? Is the idea to always have a straddle on, perpetually selling the old one and opening a new one, or only to have one on for certain days of the week?

Jeff Augen: I wouldn’t keep the straddles on all the time. For example – the most active days are usually during the middle of the week. Thursday and Friday are dominated by expiration forces for stocks that have weekly expirations and Monday often has little to no financial news. So the best way for any given stock is to sort price changes by day of the week and if one day stands out as more volatile then choose this day to own a straddle.

OPReader: “What does Jeff think of Vol arbitrage trade (Long Vega on Underlying/ Short Vega on Overall Market) during pre-earning time. “How do you address theta risk?”

It’s a great strategy but as you mentioned, time decay is the most serious risk. I also trade the difference between realized and implied volatility for individual stocks.

OPReader: What kind of trading strategies would Jeff recommend as most suited for these (now and say the next 6 months) volatile times?

Jeff Augen: Calendar spreads, ratio spreads and skilfully constructed weekly straddles. Pls also review “Day Trading Options” and “Trading Options at Expirations” to understand various strategies available for option traders. It also makes sense to search for steep implied volatility skews and to structure ratio put backspreads on these stocks for a credit. If the market (and the individual stock) continue climbing then the credit of the trade is retained as profit. If, however, the stock falls sharply then profit is obtained from owning the ratio. Two stocks that come to mind are Research In Motion and Apple. RIMM has experienced sharp declines and Apple has experienced large moves in both directions.

OPReader: The book “Microsoft Excel…” is filled with Excel and VBA examples. But is the reader expected to type in all codes and formulae and to build the model from scratch? What different type of codes Mr Jeff is willing to share that OptionPundit could host? It will be win-win proposition for OP, Mr Augen and both of your followers.

Jeff Augen: I can’t post the codes as those are with the publisher and they own the copyright so the decision is up to them. I shall connect with them to review the possibility of making downloadable code available since the book has been in circulation for some time. Separately, I shall review codes available with me that I can publish on OptionPundit.com.

OPReader: In ‘Day Trading Options‘, when you calculate the number of 1.5 standard deviation moves for, for example, ISRG, you use the 20 day historical volatility to determine when such an event occurred; When you then go on show the value of a 1.5 standard deviation for the strangle, you use the implied volatility to calculate that. Shouldn’t you be using the historical volatility for that as well? Also, if 1.5 standard deviations are fairly common for a stock, how is that move not priced into the options?

Jeff Augen: The assumption was that option prices fairly represented historical volatility and that the largest moves of the stock would generate profitable trades. The initial calculation that counted the number of large moves used historical volatility because historical option implied volatility data can be difficult to obtain and is often inaccurate. However, the point is completely correct and in the best of all possible worlds all the calculations would use historical implied volatility. The difference comes sharply into focus during earnings season when option prices rise sharply. During such timeframes it becomes very important to make sure that the effect of a modest price change is not swamped by very large implied options volatility.

Many stocks have a history of poor fit to the normal distribution so large price spikes occur more often than option pricing theory would predict. These situations are difficult for option traders because buyers are reluctant to overpay for events that happen infrequently and sellers try to avoid being undercompensated for risk. In such cases bid-ask spreads tend to widen. But whenever the price change behaviour of a stock is a poor fit to the normal distribution the number of large spikes becomes a unique opportunity for option traders.

OPReader: Is there any way to ask you questions; forum, email address, blog roll, paid or otherwise?

Jeff Augen: I write a weekly column for Stocks, Futures, and Options magazine and people often post questions about the columns. I can also be contacted through Pearson Education – the publisher. However, I try to avoid making my email public and I don’t maintain my own website. In the future, you might also connect with me via OptionPundit.

OptionPundit: Thank you for your time Jeff. 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 achive better winning consistency. I look forward to future conversations.

Jeff Augen: 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 appreciate it.

Profitable Trading, OPикони