Tony Battista: Thomas, we're back my friend, The Skinny On Option Math.
Tom Sosnoff: Yes, The Skinny On Option Math. I need some option math right now. What's it going to take to make some of this stuff turn around? That's what I need to know.
Tony Battista: Jacob in the house and you did shave your mustache!
Jacob P: I did.
Tony Battista: Partially. It looks like you're trying to grow it back now. Maybe that's - four dollars to the down fourteen.
Jacob P: I'm sorry. I shaved it because-
Tony Battista: You should be sorry.
Jacob P: People pointed out I was cheating on Movember.
Tom Sosnoff: What do you mean cheating on Movember?
Jacob P: Movember.
Tom Sosnoff: Yeah what do you mean?
Jacob P: Well because you're suppose to grow a mustache over the course of the month of November.
Tom Sosnoff: Right.
Tony Battista: You did it in October.
Jacob P: In August.
Tom Sosnoff: Yours wasn't a Movember mustache.
Jacob P: No but it was a Friday night and I was talked into something, so I shaved. Now I'm still trying to grow it back.
Tony Battista: You're hurting me. You're hurting my account too.
Tom Sosnoff: You guys still play, do you still play board games over at Will's?
Jacob P: At Will's? I haven't done that in a while. I think it still happens every once in a while. I mostly stopped after JR left.
Tom Sosnoff: Okay.
Tony Battista: Are you going to go play board games or something?
Tom Sosnoff: No, no.
Tony Battista: I'm just asking.
Tom Sosnoff: No. They used to have a night where they'd go play. I lived in the neighborhood, so I would come over just to make sure the team was all there, everybody was under control. Alright you ready?
Jacob P: I think so.
Tom Sosnoff: We got some good stuff today. It looks like we are going to cover for, I guess this is just kind of an extension of, right?
Jacob P: After last time I realized there were a couple of things that would be useful for people to be able to see directly and also a couple of things that are sort of worthwhile warnings about using this technique, that we can cover.
Tom Sosnoff: Just to refresh memory. We talked about extending duration, in an effort to create an effect that would be similar to, in other words if we weren't able to find a trade with high volatility in the short term but it was underlined that we really wanted to trade because of recruiting purposes, we can extend duration to create some kind of simulated environment that looked the same mathematically.
Jacob P: Yeah we changed the effect of volatility, so the actual volatility numbers that we see are all quoted annually. They're the annual standard deviation on returns. In practice most people don't work annually, you're not putting in trades with a year out till expiration.
Tom Sosnoff: I don't think so at all.
Jacob P: You sort of have this built up knowledge of this number for volatility corresponds with this sort of behavior. Everyone has this pre-built in intuitive conversion rate between the annual volatility that they see and sort of either monthly or forty-five days. Which ever they're, you know, you're used to.
Tom Sosnoff: Okay.
Jacob P: Of course you could convert it to other time frames also and the scaling rule behind this is that the square root of time. Volatility will, if you change the amount of time, volatility or standard deviation will always change at the square root of time.
Tom Sosnoff: Okay, I got that. They actually have a very nice song written about that.
Jacob P: This gives you the ability to , if you have a little volatility in an underline that you want to trade, to sort of get a higher effective volatility by extending your duration.
Tom Sosnoff: Okay so that's the distinction, is the effect of volatility?
Jacob P: Yeah.
Tom Sosnoff: Okay got it. Last week, we saw how efficient market hypothesis and little else, ensured us that changing duration altered effective volatility by the square root of the change in duration. Here's a crib sheet for anyone accustomed to forty-five days to expiration.
Jacob P: Last time we were doing quick like okay so what is sixty days? What is thirty days? Let's put it up there and just have a quick crib sheet, so you can get good approximations.
Tom Sosnoff: I like, you always have to make it so difficult, you can't just make it simple math for the simpletons.
Tony Battista: That's the crib sheet?
Jacob P: The decimals are on the right. The decimals are the easy ones.
Tom Sosnoff: Got it.
Jacob P: The exact number is on the left. At ninety days that's double the forty-five normal expiration so that's a square root of two factor on your volatility.
Tom Sosnoff: Let's understand what this means. If I were to go out to ninety days, it is one point four one percent of the current implied volatility number?
Jacob P: Not percent but multiple, multiple of the current number.
Tom Sosnoff: Oh, I'm sorry, so implied volatility is, let's say it's twenty, so you'd multiple twenty by one point four one, so it becomes the equivalent of two point eight-
Jacob P: Two point eight two. Yeah, two point eight two.
Tom Sosnoff: Two …
Jacob P: Twenty point eight, twenty-eight point two.
Tom Sosnoff: Okay two point eight two. I said twenty-nine.
Jacob P: Yeah I was off at, yeah, exactly and the other ones are similar but they give you a good scaling as you go. One of the things that you can note from the chart is that your loses look like, your loses in volatility get smaller when you go down to below forty-five, right? There's the ones on the right are sort of the opposite effect of, what if you wanted to be trading faster? You want to get more occurrences in, you had a high volatility and you were going to like sort of-
Tom Sosnoff: Isn't that meant to discourage?
Jacob P: You're going to lose volatility to doing … You're going to lose volatility to shrinking your duration but you're going to gain the opposite, gain the inverse effect. You get to put on more occurrences, you get to get your money, you get to trade in and out faster.
Tom Sosnoff: Everybody this will be in the archives but what we'll do is, we're going to use this now. Tony make a, save this, make a copy, because now when we're on the show, what this does is essentially … Let me just, let me make sure I understand this because this is not blowing my mind but what this is doing to me is it's putting real, hard, context around something that I've always wondered. I've always just made these dumb guesses, so if I have forty-five days to go to expiration, I really like to trade because whatever, and all of a sudden I want to move up the time frame for whatever it is. I'm really based on these numbers here, I'm giving up gigantic edge.
Jacob P: I mean, depending on, I don't know what gigantic edge means but yeah you're giving up some choice about-
Tom Sosnoff: Yeah.
Jacob P: You're trading, how long you're willing to let this trade take you, for how much volatility you want to have in it.
Tom Sosnoff: Right, but so essentially if I'm going to go from forty-five days down to let's say twelve or thirteen days, which is why you don't trade in that twelve or thirteen day slope, piece of it, you're going to give up half your trade.
Jacob P: Yeah about half of your volatility.
Tom Sosnoff: Right.
Jacob P: About almost half of your volatility which is going to change your premium by a lot.
Tom Sosnoff: That's really interesting. If you go out to ninety days it's going to be one point four. If I go out seventy-five days, one point three, perfect I got it.
Jacob P: Yeah, I thought that, because last time we were trying to do arithmetic in our heads and I was like, alright no we should have this written down.
Tom Sosnoff: I got it. It's beautiful. Batt' don't lose that.
Tony Battista: I will do my best.
Tom Sosnoff: We're not going to need it very often, but, because I got ninety, seventy-five, and sixty down. I'm trying to think of when I would use the seven and a half, fifteen, and thirty days. I think it's good that we can have that discussion now.
Jacob P: Right.
Tom Sosnoff: What does it do for us? Outside of what we just talked about.
Jacob P: I think we're about to go over what we were just talking about. It let's us pick an underline that we want that sort of has a slower volatility than we were hoping for and still trade in it, in a reasonable way.
Tom Sosnoff: Which actually creates a lot more occurrences.
Tony Battista: Correct and that's what you want, right? You need a number of occurrences to make the number work.
Jacob P: You get more occurrences because you get more trades that you want to do. You get fewer occurrences than you would if the volatility had been naturally higher, because all of a sudden each occurrence takes longer. You have to let them play out for longer, everything scales.
Tom Sosnoff: Right, so the other day, I'm looking at some stock. What the hell stock was that? Dammit I can't remember. It was some, it may have been some gold stock like GDX or GLD, or something like that, and it had between eighty and a hundred percent implied volatility. I was really just trying to figure out, for my positions, where it was suppose to be optimal. This is one of the cool segments because of the cheat sheet.
Jacob P: Right.
Tom Sosnoff: Now I have it. Beautiful
Jacob P: Now you can do it whenever.
Tom Sosnoff: Now I can do it whenever.
Tony Battista: No it's right.
Tom Sosnoff: If I need, so if I have forty-five days to go, I want to rehash this so everybody grabs it. So if I have forty-five days to go to expiration, and I have IV rank, because these are rank?
Jacob P: This is what we're were about to discuss, is that while this gets you a higher effective volatility as far as premium cost and probability of profit and things-
Tom Sosnoff: How do [crosstalk 00:08:46] into rank?
Jacob P: It does nothing about rank, because it's, when you change your expiration it changes all of the volatilities, together and so it's not going to change rank at all.
Tom Sosnoff: It has to, but it has to change rank.
Jacob P: It doesn't.
Tom Sosnoff: Okay, I got to think about this.
Jacob P: In rank you're comparing volatilities to other volatilities and when you change your days to expiration, you're going to scale all of those together.
Tom Sosnoff: Okay.
Jacob P: They're not going to change order.
Tom Sosnoff: Okay, so I'm thinking about, then how is this, but I am comparing … Alright let me think about it, let me think about it. By extending duration we can stay active [crosstalk 00:09:31]
Tony Battista: You're assuming that all the volatility is the same throughout all the months, right? Or fairly close.
Jacob P: There's the separate question about mean reversion volatility. The initial computations we're doing are sort of in a Black-Scholesy world, where volatility never changes. Which, of course, is not true.
Tony Battista: You got it.
Jacob P: It's still, it's never going to change the vol rank because the vol rank is, the vol rank is really, you can think of it as being based off of the annual volatility and that your scaling to effective volatility for each option that you want to consider there's the effective volatility of the underlining with that option, which has expiration time in it but that doesn't change the vol rank.
Tom Sosnoff: Got it. Okay, In order for everything to play out as it would have with a normal volatility level all you have to do is be patient, but this does not mean that you won't be able to keep some, keep up the same number of occurrences as you would have been with shorter expirations.
Jacob P: If you're only running your trades at ninety days, you're only really going to be able to make half as many trades as if you're running a forty-five days because they take you ninety days.
Tom Sosnoff: That's right. Okay, that part is easy got it. Conversely during periods of high volatility, choosing to trade options with shorter duration will lose some of the advantage that comes from the high volatility in exchange for letting us have a high number of occurrences while the getting is good.
Jacob P: You probably wouldn't do this when it's twenty but suddenly if volatility is really high then you might consider going down below forty-five, maybe even below thirty. Just so you can get more trades on and through while you're in this very favorable environment.
Tom Sosnoff: Is there something to be, to going longer term then, so you can get more, not necessarily more trades on, so you lock in that high volatility for a longer period of time.
Jacob P: Right so you can't lock in the high volatility, the volatility is going to keep changing, but you're going to have traded something, especially-
Tom Sosnoff: You lock in when you make the trade, that's all I'm saying.
Jacob P: Right, so there is something to that and it depends on how your directional assumptions on volatility work and also just how many occurrences you feel like you need and really the thing comes down to a capital, right? The longer trades are going to tie for capital for longer, and if that's not a concern then yeah you can [advantage 00:11:36] that, but if-
Tom Sosnoff: Well it wouldn't be a concern in periods of really high volatility.
Jacob P: If you're restricted, if you're constrained by your buying power, then you might want to consider going to these shorter term, lower buying power, reduction things, just to get more of them through.
Tom Sosnoff: So what doesn't this do for us?
Jacob P: The thing that it doesn't do is, it doesn't change rank.
Tom Sosnoff: Got it.
Jacob P: That's the important thing to keep in mind is that while it's going to get you more volatility, which is going to, it changes probability of profit, your probability of [touch 00:12:01] it affects all of these things in a way that you think it does. It doesn't change IV rank, because it's not going to, and what ever mean reversion properties volatility has-
Tom Sosnoff: How do you separate it then? How do you separate from, how do you know … Like for me, how am I suppose to know, if it doesn't affect rank, then if something has a three rank or a five rank or a twenty-five rank whatever it is. I'm still going to have to stay away from it.
Jacob P: You still, probably don't want to expand things. There's maybe even more of a technique to use, not necessarily in an underlying that's experiencing a period of low volatility but in some underlying that you want to trade, where it's typical volatility are all kind of small and so there's not much premium made. Those sort of underlying are a good choice to go to long duration on.
Tom Sosnoff: So it's more like XLE. Using XLE for example, so here's a stock with an implied volatility of whatever it is, twenty, twenty-two, but it's your ability to get high IV out of a twenty-two IV stock.
Jacob P: Right.
Tom Sosnoff: Got it. Okay, while changing the date to expiration affects all volatilities in the same way and even so when we have changed the effective volatility for an option, the volatility rank for the underlying will remain the same, like you said. This means that while we might be able to control probability of profit by adjusting days to expiration, we won't be able to use this to exploit volatility's mean reverting properties. Okay, that makes sense.
Jacob P: Which is, sort of, the IV rank. All [inaudible 00:13:33] is sort of trying to get an edge out of volatility's mean reversion. Changing your duration can't really help you with that.
Tom Sosnoff: What this is designed to do really, now that I see it. What this is designed to do is take a low vol stock and give you a higher implied volatility to trade off of.
Jacob P: Right. That's exactly what it does.
Tom Sosnoff: That's it?
Jacob P: Although, there's a sort of a [converse 00:13:57] to this. It doesn't change your IV rank. Which means that maybe when we were thinking about how much we're going to lose when we went down to shorter trades and things that were, currently had high vol. We weren't losing as much as we thought, because we're not changing rank, we're just changing effective volatility and so I think this maybe makes a good case for, during periods of very high volatility rank in a naturally high volatility underlying, then you might be encouraged to go down to like fifteen day expiration, thirty day expiration, these relatively short things, because you're still going to get your vol rank effects working in your favor and you're going to get a lot of trades in on them then.
Tom Sosnoff: Got it. Got it, got it, got it. Actually so this one I completely …
Tony Battista: There you go. You got it.
Tom Sosnoff: To make this trade, this makes trading with shorter expirations even more attractive during periods of high of high IVR, since you can get more occurrences during periods with a directional volatility assumption. However, the mean reversion property for volatility is too poorly understood to be confidently predicted, at least in theory.
Jacob P: So I would have liked to ended this with a, and here's a formula for what the effect on, if we're going to use this during a high IVR and we're going to shrink our time till expiration, what sort of effect do we think that's going to have on this works. The problem is, the theory that works well is the Black-Scholes theory, but the Black-Scholes theory doesn't think volatility changes at all so in particular doesn't think the volatility mean reverts and the other models that include mean reversion for volatility, are all sort of bad in various ways.
Tom Sosnoff: Got it.
Jacob P: I wouldn't put too much stock in, ba-dum-tish, in any of them, and so this is probably more of a question for like the research team or some sort of empirical study for, if you look to very high IVR and then start doing the short, start putting on short term trades, how effective is that?
Tom Sosnoff: We did one on that, but it was mediocre. It was a mediocre answer. It basically said there were a few opportunities but for the most part it was-
Tony Battista: Not worth the bang for the buck.
Tom Sosnoff: It wasn't worth it. It wasn't worth it.
Jacob P: The answer might be that it requires a very high IVR. You don't want to be doing this until you're up in the top ten percent of your volatility rank.
Tom Sosnoff: Still didn't work.
Jacob P: Still didn't work? I don't know.
Tom Sosnoff: Still didn't work. It got better and it was closer but the problem was that it didn't outperform.
Jacob P: Okay.
Tom Sosnoff: If it doesn't outperform-
Jacob P: Why bother?
Tom Sosnoff: Right, exactly. It got you close.
Jacob P: Well so, there is one reason if it doesn't outperform but doesn't underperform, it does get you more occurrences, right and so you'll get more reliable predictable results and so there is a reason to do it then. If you-
Tom Sosnoff: What did they do? Plus eighty.
Tony Battista: I think so.
Tom Sosnoff: Plus eighty.
Jacob P: This is still a good trick, if you're in an extremely high IVR and you want to get your nice reliable high occurrence results, you can start shrinking your days to expiration.
Tom Sosnoff: Actually what this does is it really helps us to, you'd really be surprised how much this helps us to explain a lot of situations, because not everybody is going to get this the first time around but it helps to explain situations. I think it's one of the more valuable pieces you did because, it helps me now, explain the two differences between implied volatility and IV rank and also how that applies to duration. Now when we're doing a session and we're talking about this it's pretty easy. We have a low, I'm doing it all the time. What was the stock with the issue? Was it IBM? Was it IBM or Apple? What was it? Here I'll give, go to Apple for a second, just for a second.
Tony Battista: Trade page?
Tom Sosnoff: Yeah, yeah sure. You have a second?
Jacob P: Yeah I think so, two minutes.
Tom Sosnoff: If we go to Apple. Just to put this out because I want to, If we go to Apple, we look at December options, okay, you're looking at, on the right hand side of the page we're looking at twenty-one percent implied volatility. Okay and that's thirty-six days to expiration. What we're essentially saying here is, if we went to, and I can't see the February. How far is February? Ninety-eight?
Jacob P: Ninety-eight.
Tom Sosnoff: Let's just say you went to February ninety-eight days, right? Just open that up, just open that up, so if we're looking at February ninety-eight days, which is currently at almost twenty-four, twenty-five percent volatility. What we're really saying is that by extending, by using February, instead of using December, we're really working at an implied of twenty-one times one point four.
Jacob P: Right.
Tom Sosnoff: Okay, but then why wouldn't the February reflect that?
Jacob P: Because both of those numbers that are up there are re-scaled to annual.
Tom Sosnoff: Got it. That makes sense, so they're re-scaled to annual.
Jacob P: All the IV numbers that we ever look at are all scaled to annual, but the that actually matter to us are the ones that are for the option that we're trading and so the ones that are for the option that we're trading, we should scale back to the appropriate time frame.
Tom Sosnoff: If we put the actual volatilities up there that would show that.
Jacob P: If instead of implied volatility as an annual thing, implied volatility as a from now, until expiration, you would see that effect on that chart.
Tom Sosnoff: Go back to that page for a second. What you can do is, and go to where it says, where it's ROC and click on that and go to options, theoreticals, and Greeks.
Tony Battista: You want the implied volatility? Is that what you want?
Tom Sosnoff: Yeah. Hang on one second let me just see this for a second, so if I looked at the stocks, twenty, so I'm trying to figure out, because that's the put side, the call side. Shouldn't it be reflected in the actual volatility of those options?
Jacob P: Again all of the, both the actual volatility-
Tom Sosnoff: Using the formula is annualized no matter what.
Jacob P: The number that it's showing is always going to show you the annualized number
Tom Sosnoff: No matter what, even if it's for the individual?
Jacob P: Even for the individual ones.
Tom Sosnoff: I got it. I got it.
Jacob P: This is the standard about how these things are reported, that it's always going to show you the annualized number.
Tony Battista: Even the higher implied volatility in February at sixteen percent and four percent in [dec 00:19:49]?
Jacob P: I think that's an anomaly, that's not a real thing.
Tom Sosnoff: That would make sense. That's why that's so confusing. That's why that's so confusing because you look at that, and you don't really realize because there's no number that accurately reflects on the software anywhere else, that accurately reflects real volatility.
Jacob P: Right, that's showing you, yeah exactly.
Tom Sosnoff: Okay.
Jacob P: Real volatility is this mysterious quantity that no one ever gets to look at.
Tom Sosnoff: Well, all it means to me is just that, it gives you a better indication of just what everything expects to move is. It's a better indication of expected move. Here, can we go back for just one second.
Tony Battista: Sure!
Tom Sosnoff: Then this means one other thing. What this means is then, that they implied volatility that's show for February, because it's annualized, is actually understated.
Jacob P: Right, overstated, all of them are overstated. None of these are, unless you were looking, unless any of these were a year until expiration these are all going, like, it's not actually going to make a twenty-five percent move between now and February, that's really unlikely.
Tom Sosnoff: Okay, but the numbers on here relative to each other are overstated, because are understated, because they're understated, because the February number should actually be higher.
Jacob P: If what you've internalized is what a percentage volatility means to a forty-five day trade, then all of the ones out past forty-five days are going to be understated and all the ones inside forty-five days are going to look overstated. They're all showing you the same fixed number.
Tom Sosnoff: Now that doesn't really change the way we trade at all?
Jacob P: Probably not.
Tom Sosnoff: Okay.
Jacob P: It's worth keeping in mind, what the numbers it's showing you are.
Tom Sosnoff: I got it. I understand it now. And it's unbelievable. I've been doing this for thirty some odd years.
Tony Battista: You never look at it that way.
Tom Sosnoff: Oh no, no, never.
Tony Battista: Right.
Tom Sosnoff: Nobody has, no trader ever has. It's just not possible. We can't think though that. We just, no we just don't have the ability to do that, we never did, but I've been looking at some of these numbers, not like a, I wouldn't say I don't think it affects anything, I just think it's, we've go to do a better job.
Tony Battista: Very good. Good job out of you Jacob. We're going to take a quick break, when we come back, we got a bootstrapper next, this is tastylive live.
Tom Sosnoff: Hey good job.
Jacob P: Thanks.