Option Investor


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On Thursday, I threw out a question about volatility. I was wondering why volatility seems to increase when the market spikes down and increases when the market moves up. I certainly understand that the markets trade off emotion. However, it seems to me that the same flaky and paranoid traders run for the exits on a hint of bad news just as fast as the short sellers scramble to cover their positions at a suggestion of something positive.

I received some very interesting responses from thoughtful CPTI loyalists. You'll find them interesting. Here are just four of them.

Mike --
From "How Markets Really Work," by Larry Connors, The VIX measures market sentiment and is used by professional traders to gauge the amount of fear and complacency in the marketplace. High VIX readings are usually accompanied by a market that has recently declined and low VIX readings are usually accompanied by a market that has recently risen."

He recommends not using static numbers with the VIX, but instead use readings that are 10% above or below a 10 period moving average. My own experience is that this is not an immediate signal but an excellent heads up. -- J.G.

Mike --
The CBOE Volatility Index (VIX or VXO) is a measure of IMPLIED VOLATILITY for the S&P Index. If my memory serves me correctly, it uses a ratio of weighted average of the implied volatility of eight different options: Four front month and four back month, two calls and two puts each month. I do not know the exact weightings, but I recall it is structured similar to the ARMS Index where a rising VIX is indicative of falling prices, but not a guarantee. Fluctuations in the denominator of the equation without a commensurate move in the numerator can cause movement, or vise versa.

But why does the Index rise quicker than it falls? Well, I see put volatility (both front and back month) is slightly greater than call volatility, which helps explain why falling prices pump the index quicker than rising prices deflate the VIX. Perhaps that, in conjunction with other factors such as time to expiration and other general market conditions such as "climbing the wall of worry"; all contribute to this phenomenon. After all, just a quick glimpse of most any chart shows how much steeper down moves are as compared to most up moves. Logic would lead one to believe greater volatility (IE the potential to move a given distance in a given period of time) would occur with falling market prices.-- K.H.

Mike --
My theory is that spreads widen when the market is falling because of hedging. Brokers and Market Makers often hedge their intraday risk (or excess inventory) via delta hedging i.e. buying or short selling the underlying to match the change in the theoretical value of the options. In a falling market short selling (delta hedging) becomes difficult due to the high demand of short sellers (to hedge) and the limited supply of lendable stock or underlying. It is always easier and cheaper to buy a stock than short sell it. As demand increases, the overnight stock lending rate increases to match demand and the stock becomes a "special." This makes it more expensive to short sell to hedge a downward option exposure. As the market makers and dealers find it harder, and more expensive to hedge their intraday inventory, the bid-ask spread widens to reflect the additional "naked" or unhedged inventory risk. This often results in a steepening of the vol & "smile"; and an overall increase to VIX (remember under the new VIX methodology all option strikes are used, not just the at-the-money as was the case in the old VIX methodology). The Market Makers and Dealers also realize that they are likely to suffer from a "short-squeeze"; when the market bounces back (and they are forced to cover), and this risk is factored into their bid-ask spreads. - A.M.

Mike -
The VIX Measures volatility. Volatility is summed up as the measure of the rate of change of prices. The VIX itself uses a number of at the money calls and puts, and avereages the daily price movement and volume of the selected calls/puts.

When the market goes higher, investors are more complacent, call buying is more prevalent than put buying, and a overall warm and fuzzy feeling rests with traders and investors. When the market goes down, put buying is more prevalent, the market is more frenzied, traders are less complacent, and the rate of change of prices is higher.

Simply put, the VIX would be better described as a measure of human emotion, because essentially that is what it is measuring. The amount of trading based on emotion in the market place (when the market goes down) outweighs the amount of trading based on emotion when the market goes up.

There is a great book, called "A Random Walk down Wall Street" by Burton Malkiel. It explains this phenomenon very well. Mr. Malkiel outlines this phenomenon from it's roots, (The Holland Tulip Craze) to modern day instances, like QCOM in the late 90's.

Every trader has experience with this, do you think more clear when all is well, or the 'sky is falling'? - Mike Cavanaugh, BrokersXpress.com

Food For Thought
Well, there they are -- food for thought. Each opinion makes good points. There were a number of others, too. I think it may make for an interesting debate at the Chicago CPTI seminar coming up on August 12th & 13th. There are still some spots left - room for serious traders who want to learn.

S&P Support & Resistance Levels
With the market moving up, here are a few levels to watch.
S&P 500: Closed at 1278.55
Resistance: 1272 to 1268 is the November and December 2005 closing highs and March 2006 closing low
1280 is the recent July peak.
The late January peak at 1285
The early June high at 1288
1297.57 is the recent February high.
1315 is the May and May 2001 peaks
1317, the recent intraday highs from April.
1324 to 1329 from the October 2000 lows.

Support: The 200 day EMA at 1266
The 50 day EMA at 1263
1252 is an old trendline from the August 2003/August 2004/October 2005
1239 from the late June consolidation range.
1225 from the March 2005 high
1223 is the June 2006 closing low.
1213 from December 2004 high to 1215
1205 from the August lows

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CPTI August Position #1 - SPX - Bull Put Spread - 1278.55
On Thursday morning, 7/6, with the SPX at about 1273, we put on our first position for August - 12 contracts of a bull put spread 1175/1160 for a credit of $.60 ($720). I watched as hundreds and hundreds of the 1165/1150 spreads were filled throughout the day at that credit limit. At this writing, we have a nice fat 90 point cushion.

CPTI August Position #2 - RUT - Iron Condor - 700.03
On 7/10, with the RUT trading at about 713 we sold 15 RUT August 780 calls and bought 15 RUT August 790 calls for a credit of $.65 ($975). Then we sold 15 RUT August 630 puts and bought 15 RUT August 620 puts for a credit of $.50 ($750). Total net credit of $1.15 ($1,725). Max profit range is 630 to 780. Maintenance is $15,000 - IF you have the right broker.

CPTI August Position #3 - SPX - Iron Condor - 1278.55
On 7/17, with the SPX at about 1235, we sold 12 August SPX 1125 puts and bought 12 August SPX 1110 puts for a credit of $.60 ($720). Then we sold 12 August SPX 1310 calls and bought 12 August SPX 1325 calls for a credit of about $.60 ($720). Total net credit and profit potential of $1.20 ($1,440). Max profit range is 1125 to 1310. Maintenance is $18,000.

CPTI August Position #4 - RUT Iron Condor - 700.03

On Friday afternoon, 7/21, with the RUT at about 671, we sold 15 August 600 puts and bought 15 August RUT puts for a credit of about $.65 ($975). Then we sold 15 August RUT 740 calls and bought 15 August RUT 750 calls for a credit of about $.50 ($750). Total net credit and profit potential is $1.15 ($1,720). Maximum profit range is 600 to 740. Maintenance is $15,000 - IF you have the right broker.

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ZERO-PLUS Strategy -
In the past, I outlined a strategy based on an initial investment of $100,000. $74,000 was spent on zero coupon bonds maturing in about seven years at a value of $100,000. The principal $100,000 investment is guaranteed. We're trading the remaining $26,000 to generate a "risk free" return on the original investment. We are not compounding our profits by dramatically increasing the number of contracts we trade. Just think of how well we would be doing if we had increased the number of contracts, even a little.

Our July RUT Iron Condor position expired worthless - according to plan. We can now officially add the $2,300 of premium to our cash stash - to take us well over the $40,000 mark. We have now generated $44,950 ($42,650 + $2,300).

NEW Zero Plus Position: RUT Iron Condor - 700.03
On Friday 7/21, with the RUT at about 671, we sold 20 August 600 puts and bought 20 August RUT puts for a credit of about $.65 ($1,300). Then we sold 20 August RUT 740 calls and bought 20 August RUT 750 calls for a credit of about $.50 ($1,000).

Total net credit and profit potential of $1.15 ($2,300). The maximum profit range is 600 to 740 - 140 points. Maintenance is $20,000 - IF you have the right broker.

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Now you have two choices for which CPTI seminar you'd like to attend. Don't put off making the reservation. Airline tickets get more costly the closer you get to the event. If you really want to take your trading from a "hobby" to a potentially profitable "business," you'll want the information you'll learn at my CPTI seminar. You'll learn more than the "how to's" of trading our strategies. You'll learn a new lifestyle - and a nice lifestyle - one that can last a lifetime.

It's always a challenge (and a pleasure) for me when I have a roomful of bright people who have a passion for, and are excited about, learning. We go over everything imaginable - from the non-directional strategies to the psychology of trading. We cover a lot more than the mechanics. Inquiring minds want to know the whens and the whys, not just the hows. That way, they're prepared for the best (and the worst) - and know the best way to handle either situation. There are still spots open for Chicago. Contact me and I'll call you with all the details.

If you're a SERIOUS options trader and you want to learn the nuances of our advanced non-directional trading strategies and hone your trading skills, contact me ASAP at mparnos@optioninvestor.com. I'll call you with all the pertinent information. The price is a bargain - ONLY $995.00 -- less than the profit from one Iron Condor trade -- and you'll have a two-day experience that you'll remember, and profit from, for a lifetime. Our CPTI seminars are limited to ONLY 25 ATTENDEES.

The San Francisco CPTI Seminar was a great success (no surprise, they all are). There are now more enlightened minds, with smiles attached, ready to generate a healthy annual return using our CPTI strategies. Remember, if you attend one of my CPTI seminars, you are entitled to RETAKE the seminar a SECOND TIME at NO CHARGE!


You should really try and make one of my seminars, if you can. With what you learn, you'll see a substantial increase in your trading results. Contact me at: mparnos@optioninvestor.com. If you've already signed up, I'll see you there. If you haven't signed up, what are you waiting for?

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Remember the CPTI credo: May our remote batteries and self-discipline should last forever, but mierde happens. Be prepared! In trading, as in life, it's not the cards we're dealt. It's how we play them.
MIKE PARNOS, Your Options Therapist and CPTI Master Strategist

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Couch Potato Trading Institute Disclaimer
All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices (though many often do) or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what. It isn't the fault of the strategies

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