Tony: Thomas, we're back my friend! The Skinny on Options Math with special guest star!
T.P.: And, I'm feeling skinny.
Tony: You're looking skinny. You're looking good T.P. How are you?
T.P.: I'm good, thank you.
Thomas: You're making your first appearance on the Tom and Tony Show this week.
T.P.: What? Oh, yeah, you mean this week. Yes.
Tony: Don't listen to him. Yeah, you've been on other shows. You've been on …
T.P.: You mean the Tom and Tony, the Tony and Tom show.
Tony: Yes.
Thomas: But you've been on other shows. You've been on ..
T.P.: No, I haven't. I'll be on Slimmy Show today. No, I got axed from the Liz and Jenny line.
Thomas: They fired you?
T.P.: Yeah.
Thomas: I don't blame them. I just …
Tony: I was wondering what took them so long.
T.P.: I was let go.
Thomas: You were let go.
T.P.: I was let go. They didn't say I was fired specifically, it was more like "T.P., we're (psssss…)…
Thomas: We've moved on.
T.P.: … we're reallocating some resources. So, where's Jacob?
Thomas: He's visiting family out of the country.
T.P.: Out of the country?
Thomas: He's in North Korea, okay? North Korea, yes. I didn't want to …
T.P.: (laugh) We're gonna see him on CNN. We were talking about this. I can't believe they cancelled that movie. See, I'm not a movie guy. That was the only movie I would have seen.
Thomas: Of course it is.
T.P.: Because, it was like …
Thomas: I don't blame you.
T.P.: … movies, who cares? But that looked like a fun movie.
Thomas: I don't blame you. I totally agree.
T.P.: So, I'm disappointed …
Tony: Now you'll just have to get it from the other places you get your bootleg movies from.
T.P.: Easy over there.
Thomas: Now you're just gonna have to spend the whole Christmas Holiday watching reruns of tastylive.
Tony: That's right.
T.P.: That's right. Wau, wau, wau, wauuuuu.
Thomas: What are we doing today?
T.P.: We are doing vomma. Quantifying high premium with vol, vega and vomma. Vol, vega and vomma. I hate these names too.
Thomas: I hate these names.
T.P.: I hate these names. Why don't they call it, like …
Tony: Vulma, they should call it.
T.P.: …Jimmy. Jimmy. I got some Jimmy on. What's the Jimmy? 3.8.
Thomas: I like that.
T.P.: Something like … rather than sort of these twisted attempts of creativity. Drives me nuts. What this study does is, we've talked a lot about why or how option premiums respond to higher volatility. We've seen the VIX jump up from the 12 handle a couple months ago to up over 20 a couple days ago, back down to 16, down to the 16 handle this morning. What is the impact on option prices? We know that higher volatility, we saw this in the last study, obviously.
Thomas: Sure.
T.P.: Higher VIX means higher potential profits, but how does that change? Why does that change the way it does? That's what vomma describes.
Thomas: That's interesting. Let's see what we got here, Mr. T.P.
T.P.: Let us plunge in.
Thomas: Let us plunge in. So, he is Tom Preston. He is one of … what are you here? You are …
Tony: (laugh) What are you here?
Thomas: …you are one of our experts. He's one of our experts. Tom is …
T.P.: I like to be more of an inspiration.
Thomas: I'm sorry. He's one of our inspirations.
T.P.: I like to be an inspiration.
Thomas: You're an inspiration.
T.P.: I think it's … expert is kind of limiting.
Thomas: You're right.
T.P.: I like to be inspiration because I cover a lot of bases. I get asked about advice on a lot of subjects.
Tony: You're the 'fixer'.
T.P.: A little bit, and also kind of a sounding board for a lot of people with various problems in their life. I sit over there at the end of the lunch table and they come to me.
Thomas: When Tom first joined - think of him as one of the original 7 - as we like to say.
Tony: The Magnificent 7.
T.P.: The Original 5.
Thomas: That was taken already.
T.P.: What about the Original 5? I was one of the cardboard boxes (laugh).
Thomas: His mom …
Tony: You were a box boy.
Thomas: His mom called me up and she said "You know Tom …
Tony: Nobody will talk to my boy T.P.
Thomas: My son wants to be an inspiration. Please don't disappoint. Please don't disappoint.
Tony: Help the family.
Thomas: Help the family. And I said …
T.P.: Mother Preston.
Thomas: Mother Preston. And I said "I will make it my mission in life to make your son into an inspiration".
T.P.: An inspiration for us all.
Thomas: In the world of finance.
T.P.: So, I've got to figure out a Christmas gift for Mother Preston still.
Thomas: Mother Preston's …
T.P.: Cutting a little close. Got 7 days. Not a whole lot to get when you're 92. She's 92 now.
Thomas: You're FedExing it.
Tony: God Bless.
T.P.: I may have to drive it up.
Thomas: Okay. Barbecue sauce.
T.P.: It's always a winner, isn't it? Salt Lick Barbecue sauce is always a winner.
Thomas: I think you'd better take a flight straight from here. That's what you need to do. Anyway, we know that higher applied volatility means higher option prices. The relationship is described by vega, which is how much the price of an option changes when implied volatility changes 1 point. So Tom, just give us kind of a basic, vague explanation as volatility goes. Here, let's use real examples. Now, the first thing people are going to ask is "Are we talking about the VIX, are we talking about the VIX future? When you use the term 'volatility', what are you looking at?
T.P.: Okay, very specifically in this example for vega, it is when the individual implied volatility of an option changes. So if I pick in, what are you trading today, the SPX, for example.
Thomas: Sure.
T.P.: So, if I look at maybe the Jan options, something out of the money, I want to sell a call or something like that. I look at maybe the 2200 call. Something like that. Just pick a number. That's going to have an implied volatility. All of this stuff is very mechanical. The market forces drive the bid asked, the market pressures (this is why we talk about liquid products) push the mid price of a bid asked to a fair value. That fair value then is converted to an implied volatility. Okay? This is what creates the skew. The different implied volatilities at each strike is what we call the skew. If I see that volatility of that option, that out of the money call at, let's say, 18%, if the option is trading at $2.00 and the vega is $1.15, if the implied volatility of 20 goes to 21 that option will go from $2.00 to $2.15.
Thomas: Got it.
T.P.: Theoretically.
Thomas: Got it.
T.P.: Now, it's not exact. That's where this vomma thing comes in. In the non-linearity. None of this stuff … everything's a moving target here. Everything's a moving target.
Thomas: Don't jump ahead for 1 second because the other part of that question was "When somebody wants to look at volatility, are they looking at the volatility as the future or are they looking at the VIX?".
T.P.: Thank you. Thank you. I wanted to address this point. The individual options - the implied volatility for that individual option is what we're talking about with vega right now. For testing purposes, for market interpretation purposes, for engagement purposes, the VIX is the number to watch. Why? Because it incorporates all that information across the skew. 'So, okay. Great T.P., you picked 2200 calls. What about the 2100's? What's the matter with them?'. Nothing's wrong with them. The VIX is a nice overall number. When I say "What's the S & P trading for? $16.50, the volatility trading for $16.50.", that's the number to watch.
Thomas: Okay, so you're using VIX.
T.P.: The VIX future is a traded product that's driven off of future estimates of what the fix is going to be. I don't want to talk about the VIX futures right now. That's a different animal from this discussion.
Thomas: What most people would say is "VIX's future's down 80 cents today, and the VIX is down $3.00. I don't understand".
T.P.: What's happening there specifically is that the SPX options in the wings are getting driven down. They're taking their bids and making them offers. They're just pushing the premiums lower across the board in those SPX options. What's happening is the lower SPX options - and we can see that either through lower premium or lower implied volatilities - it's the same thing, just a different way of looking at it - getting pushed down. That's driving down the cash fix. The VIX futures don't buy it. They're like "eh, eh, we're going to be down a little bit". They're seeing that in the next month or so we could see higher volatility.
Thomas: So we also know that vega is not constant, and changes not only with time to expiration and underlying price, but changes with implied volatilities as well. Vomma is the greek that measures how much vega changes when implied volatility changes.
T.P.: That's right.
Thomas: Well, that's pretty straightforward. So let's keep going. So here's the formula. Vomma equals vega times … explain?
T.P.: Yes, you take the d1 and d2, and I'm not Jacob so I couldn't quite get the formulas written cleanly on here. D1 and d2 are the standard Black-Scholes. D1 and d2 components where you're taking the natural log, the stock over the strike plus the volatility - you multiply vega - so it's an adjustment to the vega.
Thomas: Got it.
T.P.: It creates this non-linear sort of multiplier for vega. That's what it does.
Thomas: So vomma tells us how much in options vega changes for a 1 point move in an options implied volatility. Vomma is lowest for at the money options and is higher for further out of the money options, which is the opposite of vega.
T.P.: I didn't know this going into this. I didn't really look at … I don't look at greeks a whole lot anyway. You know, what's my role? So, vega, yeah I'm aware of vega. I'm aware I have maybe long vega or short vega. I know I'm long volatility, but vomma. Never looked at vomma. It's not something I care about necessarily. I plugged it in to see what I get.
Thomas: I don't look at it either, but Tony taught me this at lunch yesterday.
T.P.: Vomma?
Tony: (laugh)
Thomas: The whole deal.
Tony: I gave him a little lesson.
T.P.: He's good that way.
Thomas: The high vomma for out of the money options means that their prices rise faster than at the money options when implied volatility increases because vega's increasing too. So vomma can quantify why we see non-linear option prices and option price increases when implied volatility increases. What that means is that when implied volatility goes up 10%, it means option prices might go up greater than 10%.
T.P.: That's exactly right.
Thomas: Which is one of the reasons we talk about … we get excited when we start to talk about velocity of certain moves because there's your mathematical equation.
T.P.: Because this is how you can get paid.
Thomas: That's right. It's not that we're ever long those options, it's just that hey, you know …
T.P.: That's a different discussion.
Thomas: For example, in the SPX options with 50 days to expiration with the SPX at 2012 we look here. We just look at the 2010 puts and the 1810 puts.
T.P.: Right. So here's something. 10% out of the money so you get a vega of 3.00. . That's obviously highest with at the money, but the vomma is teeny tiny. You have the 1810 put, 10% out of the money, with a .61 vega, so with 1/5 of the vega but about 100 times the vomma. So, the vomma is much much higher out in those wings.
Thomas: Oh boy, what do we have here?
T.P.: All right, so what this shows you 1810 put on the left, 2010 put on the right. Way out I'm out 10% of the money on the left, at the money on the right. On the far right hand side are VIX's let's say. Implied volatilities going from 12, 14, 16, 18 up to 30.
Thomas: Got it.
T.P.: The next you'll see the price for each option - these puts. SPX price doesn't change. The SPX price stays at 2012, 50 days to expiration. Only thing we're changing is volatility. Only thing.
Thomas: Got it.
T.P.: So, the 1810 put starts out at $2.63 at 12%. The 2010 put, which is the at the money, is $26.00. What happens when we start to increase volatility? I only had room to do 2 points. I wanted to go single points but couldn't quite pull that off.
Thomas: That's okay.
T.P.: What you see is the grade of … what I want people to focus on are the percent increases per 2% increase in volatility. When the 1810 put goes from 2.63 to 4.34, that's a 65% increase. For 2% increase in implied volatility it increases 65%. For the at the money put, the same volatility increases yields only 23%. That is expressed by vomma. What you see is that 1810 put has an 08 vomma compared to an .058 vomma. As volatility increases, vomma increases a little bit for the 1810 put, then backs off a little until you get to 22, 24%. The 2010 put has negative vomma as volatility increases.
Thomas: I didn't realize that it was that …I didn't realize it was that …
T.P.: Steep.
Thomas: I did not realize it was that steep at all.
T.P.: As I was doing this I thought 'You know what would be handy? Let's look at the percentage changes'.
Thomas: I know.
T.P.: It's kind of like, well, it's a 26 to 32. You think in terms of points and dollars. This is very closely tied to what we're talking about in the market measures today. What happens is …
Thomas: Yeah. I'm surprised by those numbers.
T.P.: Wait until you see what happens when you try to buy these options. (laugh)
Thomas: Do you want the next slide?
T.P.: No, let's stay on this one for a second. Here, go back for just one second.
Go back, I want to make this quick point.
Thomas: Okay.
T.P.: What happens is you get the greatest percentage changes in both cases when volatility is low and goes higher. From 12 to 14 to 16.
Thomas: Yeah, that makes sense. Yeah, that makes sense.
T.P.: What happens after 22 and 24%, of course you get increased prices. Of course you do. Volatility is going up. Vega's positive. You're going to get higher option prices. But the percentage changes are dramatically lower. This confirms a couple of things: Why the low 20%s - let's say 20% to 25 because 24% of the VIX is a sweet spot for selling premium. That's why we saw such a dramatic increase in the performance in the last study of the market measure today where VIX above 20 P & L, VIX below 20 P & L. VIX above 20 P & L was 50% higher, or 45% higher or so …
Thomas: What's the delta on the 1810 puts?
T.P.: The delta on the 18 puts, I want to say about 10 or so. A little less than 10.
Thomas: And what's on the 2010 puts?
T.P.: 2010 puts is 50. Those are right at the monies. Those are right At the monies. A couple bucks out of the money so they'd have like a 46, 47 delta, the 1810 puts are up …
Thomas: I got it.
T.P.: … 8 or 9 delta. So, that 1810 put is the one that you get the most rewarded on when VIX is high, and that fits in exactly with the results that the research team put together.
Thomas: I got it. Wow, interesting. Really interesting. The takeaways. The price of the 1810 put increases much faster than implied volatility rises in the 2010 put. The percent increases for both options are highest when implied volatility is lower and they drop after implied volatility rises past 24%. This is why we consider the VIX in the low 20's a sweet spot for selling premium. I did not know, Mr. Batt, that that was the reason.
Tony: Now you do.
T.P.: Neither did I. Now you say "Well, okay T.P. well yeah because the percentage change in the VIX is a 2 point change in the VIX from 12 to 14 is a bigger percent than when it goes from 26 to 28". Well, yeah, I get that.
Thomas: I know. I just didn't know the answer.
T.P.: But we think in terms of points. It all equalizes out more or less. Not quite, but more or less when you think in terms of percentages. We don't think in terms of per … we think in terms of VIX at 16 going to 17. Or 18. Or 20.
Thomas: Very nice. Very nice. T.P., good job out of you.
T.P.: I try. Did I inspire?
Thomas: I don't think you inspired, but you may have walked a few people off the ledge.
T.P.: I'm hurt. (laugh)
Tony: Let's take a quick break and we'll come back with that Bootstrapper next on tastylive Live!