Volatility Skew

Level: Intermediate

Introduction

Volatility Skew is a broad term that refers to the distribution of implied volatilities (IV) across strike prices for a single expiration. It could also refer to an IV-Expiry graph, but we will be focusing on the more common definition. For a two-dimensional graph, the values plotted for a skew would be the strike price on the x-axis, and the implied volatility of that strike on the y-axis.

Keep in mind, though, that in financial lingo, volatility skew and volatility smile are two separate terms, both of which describe the shape of the graph.

Volatility skew graphs are commonly available in most trading platforms.. However, to graph multiple expirations, you would need a volatility surface, which graphs expiration on the z-axis. These charts are not commonly available, but you can view an example below.

Volatility Smile

A volatility smile is a pattern in which the Strike-IV graph looks like the following:

This means that the ATM call is priced lower than the OTM options, both calls and puts. The actual price, of course, would be larger or smaller depending on the type, but the relative price difference is calculated from the discrepancy from a number given from an options pricing model (ex. Black-Scholes).

The discrepancy could be caused by a variety of factors, which depend on the type of security being analyzed. For example, a smile would represent fear of either a move to the upside or to the downside because it shows that people are willing to pay more than expected for the options, which are often used as insurance.

Volatility smile is more common in options with close expiries in the stock market or in the foreign exchange market in general.

Volatility Skew

Volatility skew is a situation in which strikes for only one side of strike prices have a higher implied volatility.

Reverse Skew - Looks like \_, — Reverse Skew – Looks like \_,

Some people call the reverse skew a “smirk,” and there are other names for different graphs. When someone refers to “skew,” they are most probably referring to reverse skew.

Reverse skew is also the most common scenario for longer-dated expiries in the equity market. This is because lower strike puts are purchased to shield against market drops. However, in other markets, like the futures market, a forward skew might exist to protect against a price spike (ex. utilities).

Evolution of the IV Surface

So far, we have been looking at what the numbers themselves actually represent. Let’s take a look at the derivative of these graphs, otherwise known as the evolution.

“Sticky strikes” is a term to represent a situation where if the spot price changes, the IV surface is unaffected for a certain strike. This is also called stick-to-strike or sticky-by-strike.

“Sticky moneyness” or sticky delta or just moneyness is a situation where if the spot price changes, the IV surface is unaffected for a certain delta. Delta is simply the variation in an options price relative to the stock price.

Modeling Methods

There are two ways that the IV can be modeled in the case of a volatility smile.

Stochastic Volatility – Quite advanced, but it simply uses a random Brownian motion process to influence a stochastic model, which cannot be exactly predicted, but can be analyzed.
Local Volatility – Simply the general definition of IV, where it is the function of an options-pricing model.

Conclusion

The volatility skew is a tool that lets one see how investors are pricing options, not just in raw dollar terms, but compared to the Black-Scholes model. There are many terms to represent the shape of the curve, and the change in the IV Surface has its own terminology.

Market Summary – 11/30/2014

Level: Intermediate

Trade Advice: Beginner

Indices:

All of the major indices dropped on Friday, but the market was still up across the board. Here is a breakdown of each major index:

S&P 500: +1.39% to end at 2,067.56
Nasdaq: +2.20% to end at 4,791.63
Dow Jones: +1.15% to end at 17,828.24

SPDR Sector Performances (%):

Energy (XLE): -1.14%
Utilities (XLU): -0.22%
Materials (XLB): +1.00%
Technology* (XLK): +2.15%
Industrials (XLI): +1.61%
Healthcare* (XLV): +1.30%
Financials* (XLF): +1.20%
Consumer Staples (XLP): +0.45%
Consumer Discretionary (XLY): +1.91%

*Currently the club is mainly tracking the technology, healthcare, and finance sectors.

Notable Stock Performances from this week:

Facebook seems to finally be rebounding in the right direction, after dropping sharply in late October. It started the week at $73.59 and ended at $77.70! We expect it to continue its rise.

Alibaba continued its crazy roller coaster trend this past week. It began the week at $111.96. At this point it was very bullish, like weeks past, and it peaked at $115.000 on Tuesday! But, it then declined sharply on Friday to end at $111.64. After peaking at $119.15 and declining to $114.15, Alibaba has refused to overcome the resistance of around $114. I recommend buying it this Monday morning, when it is low, and to sell it around mid-week when it should be at its highest, as evidenced by the trend seen in recent weeks.

Sony has steadily climbed in price the past month, after it announced plans to jump 70% in revenue over a 3 year period. Analysts have claimed that this led to shareholder hype and interest, leading to Sony at its highest value in the past year at $21.99.

Google has been on a roller coast this past week. It began the week at $542.47. On Monday it dropped to $538.91, before picking back up again on Tuesday where it ended up at $541.08. But, that isn’t the whole story. Throughout Tuesday, Google started out by peaking at its weekly high of $543.50, before declining to 541.15 within 30 min. Within an hour, it had picked back up to $543.16, before sharply declining to $538.96 at 3:00 pm. Finally, it ended at 541.08 after hours. Wednesday and Thursday saw Google hovering around the resistance level of $541, which it failed to decisively break. To end the week, Google finally broke this level by ending at $541.83. Personally, I believe this sets up Google in a prime position to have a fairly large gain next week. I would recommend buying this stock, as it is at a one month low, but take note that it is also primed for either a modest loss or a stellar gain (I explain WHY down below in my predictions for next week).

Apple hit a new all time high of $118.93 on Friday. Apple has been incredibly bullish in the past 43 days. On October 16, the price per share of Apple was $96.26. On Friday, it closed at $118.93. Although it is too late to capitalize on this gain, investing in Apple for the long run may not be a bad idea. Apple has always been seen as a popular “forever” share, a share you can purchase and never worry about as it will almost always go up. However, if you are looking for a more short term investment, Apple may still gain this next week if it manages to break the resistance level of about $119.

Evaluation of last week’s predictions:

The prediction of increased volatility in Facebook stock was correct, as FB’s one week volatility jumped to 1.85% for this week (according to FINVIZ). It did this in a bullish manner, with FB stock increasing 1.03% over the course of the week. Facebook ended up at $77.70, up from $73.59 where it started on Monday.

We correctly predicted last week that energy would retrace slightly. The energy sector so far this week has gone down 1.14%. However, our prediction consisted of two parts. We predicted that in the long run, the energy sector will increase. So, now we must analyze it in the coming weeks, to see if our long term prediction was correct.

Our president, Michael, correctly predicted that it was a ripe time to purchase the Disney stock. This week, Disney made gains of $2.58. Anyone who bought the stock on Monday would have made a 2.88% gain. However, note that Michael used LEAPS to act on this prediction, meaning that the bullish prediction was again a long term one. Therefore, the finance club will continue analyzing this prediction in the upcoming weeks.

Finally, last week we predicted that it would also be a great time to buy shares in Goldman Sachs. Our prediction has failed, at least in the short term. This past week, Goldman Sachs could not break the ceiling of about $190. It ended at $188.41, which is down about $2 from $190.14, where it began on Monday. We will still continue to keep an eye on Goldman Sachs, as it may break resistance in the coming week, which would result in a major gain.

Aabhash’s Predictions:

Facebook stock will continue to rise next, as it finally broke the resistance level of about $75 on Wednesday. This break led to Facebook ending at a one month high. Normally, breaking resistance means that the share price will most likely increase, so the stock should continue to rise in the coming week.

Take a look at FINVIZ’s quote for Koss Corporation, a headphone equipment retailer. For approximately 9 months, its stock [NASDAQ: KOSS] has been forming the bullish wedge down pattern while at the same time facing disappointing fundamentals. The result was lots of confusion among investors in the months of September and October, thus maintaining the pattern. In November the wedge down pattern was finally confirmed by a break upward. The proximal cause of this break upward was a legal insider buy (more on legal insider trading in the future) by the CEO. However, this bullish trend, only based on a technical pattern, will not continue for long. Now that the bullish force of a wedge down pattern is gone, investors will begin to act solely on the bearish fundamentals, which will drive the stock over the course of the next month.

Google is primed for a modest move in either direction. The fate of our prediction will be known on Monday. If Google can manage to decisively break the resistance level of ~$542, it will most likely skyrocket through the week. If not, Google will most likely flounder in a roller coaster trend, much like it did last week. So, keep an eye out for Google because its performance early in the week could dictate whether or not you can make money off of it.

Apple recently climbed to record highs, and ended the week at $118.93. Apple was bullish all week, peaking over $119 on 3 different days! But, there seems to be a resistance around $119 that the stock simply can’t overcome. I believe Apple will definitely break this ceiling in the near future. As of now, Apple is in a similar situation in regards to Google. Both stocks are primed to have stellar gains, but it all depends on whether or not they can break their respective resistance levels. I recommend keeping an eye on Apple to see if it breaks $119 by Monday. If Apple hits $120+ by Tuesday, you should probably buy it.

Market Blog Quote of the Week:

“Half of the investors trading your ‘hot stock’ are trying to get rid of it”.

-Charles Wheelan

Happy Trading Everyone!

*Any losses incurred as a result of recommendations made by either the President, Vice President, or Secretary are not the legal liability of the RHS Finance Club. By using our recommendations, you have waived the right to take any legal action against Rocklin High School, its Finance Club, or the Rocklin Unified School District for any monetary losses incurred on your part. Invest at your own risk, and with the mindset that you may lose money.

Warren Buffet

Warren Buffett is the most successful investor of the last century. But who is Warren Buffett? Warren Buffett is the CEO and Chairman of Berkshire Hathaway. Buffett always had a keen interest in the stock market from an early age. During a trip to New York at age 10, he made an effort to visit the NYSE. At age 11 he bought 3 shares of Cities Service.

Buffett grew up and attended Columbia Business school, after being rejected by Harvard. At Columbia Business school, Buffett learned from the great Benjamin Graham. After college, he found out that Graham worked on the board of GEICO. Buffett stormed over to the GEICO headquarters, where he met the VP Lormier Davidson. They chatted for a while about the insurance company, and to this day they are good friends. 2 years later, he accepted a partnership from Graham. After Graham’s retirement in 1956. At the time of Graham’s retirement, Buffett had amassed about $174,000 USD (1.47 million dollars USD today).

By 1962 Buffett merged his partnerships into one. He later took over a textile company named Berkshire Hathaway, which by 1966 had been turned into an insurance firm. Even though Berkshire Hathaway today has reached pinnacles of success, Buffett regards it as one of his biggest mistakes. Currently he holds a majority stake in Berkshire Hathaway.

Berkshire Hathaway is a large firm that controls smaller subsidiary companies. Hathaway owns majority/minority stakes in almost all major companies including Geico, Coca-Cola, Heinz, etc..

In 1979, Buffett made it on the Forbes 400 list for the first time in his career. Warren Buffett today is consistently ranked as one of the world’s wealthiest people, with a net worth of $67,000,000,000 USD ($67 billion USD).

Buffett is recognized for his outstanding philanthropic work and his frugal lifestyle. So far this year Buffett personally donated over 2.8 billion dollars to several charities! These charities included the Bill and Melinda Gates foundation. In 2012, TIME magazine ranked him as “One of the World’s Most Influential People.”

Sources: “Warren Buffett.” Wikipedia. Wikimedia Foundation, 26 Nov. 2014. Web. 26 Nov. 2014.

Morrell, Alex. “Buffett Donates $2.8 Billion, Breaks Personal Giving Record.”Forbes. Forbes Magazine, 15 Jan. 2014. Web. 28 Nov. 2014.

Golden and Death Crosses

Level: Beginner

A golden cross is a basic bullish pattern that forms when a shorter term moving average “crosses” above a longer term moving average. An example would be if ABC’s 15 day moving average rose above it 50 day moving average. Many technical analysts interpret this pattern as a sign that a new trend is forming or that the existing trend is getting stronger. A rise in volume immediately after the cross helps confirm the pattern.

Death crosses are the exact opposite: when the shorter term moving average crosses under the long term moving average. Death crosses are regarded as a bearish sign, and they, like golden crosses, are often confirmed with a rise in volume after the cross.

MACD

Level: Beginner

Moving Average Convergence Divergence, or MACD is a tool that can identify entry and exit points in a particular trade. It does this by determining when a trend begins and when it ends. Understanding this concept does, however, require a basic knowledge of Exponential Moving Averages (EMA). If you are unacquainted with EMAs, just give Michael’s minute blog on moving averages a good read. It should teach this concept sufficiently. That being said, the most commonly used MACD is calculated as follows:

MACD = 12 day EMA – 26 day EMA

Analysts then usually take a 9 day moving average of the MACD called the signal line. This signal line is then usually plotted alongside the MACD chart. This graph reveals trends that investors use to trade. When the MACD crosses above the signal line, traders take this as a bullish sign and they tend to purchase shares in the stock. When the MACD falls below the signal line, traders take this as a bearish sign and they usually sell their shares in the stock.

Traders also look for other trends in this graph. When the security’s price veers away from the MACD, it is called a divergence. Investors see this divergence as an end in the current trend. However, this method can often generate false trading signals.

Normally when the MACD diverges dramatically higher from the signal line, it suggests that the stock may be overbought. Normally, the market will correct itself and bring the price back down again. However, the market may not “correct itself” if the company’s fundamentals have made a drastic change.

Enjoy Your Trading!

Market Summary – 11/23/2014

Hello RHS Finance Club members! The following information is brought to you by our VP, Ken Croker, and our President, Michael Trehan.

The market had modest gains ending November 23. Here’s a breakdown of the major indices this week:

S&P 500: Up 1.2% for the week, after a large gap up on Friday.
Dow Jones: Up 0.51% for the week, large gap Friday
Nasdaq: Up 0.24% for the week, breakaway gap on Friday

Let’s break the market down into sectors: Telecommunications was hit hard, with Verizon (VZW) down almost 2.5% for the week. Energy had a nice run this week, with XLE up 3.3%. Technology was a laggard, with XLK closing up only 0.36%. Basic materials outperformed, with XLB seeing a 2.75% pop.

Predictions:

Energy will retrace slightly, with a long run upward
Facebook is still consolidating and may experience a large move in either direction
Disney looks ripe for a long term entry, which Michael has done so through LEAPS (education blog on that later).
Goldman Sachs has a setup similar to Disney, and may also be an entry-candidate.

– Michael Trehan, Pres. and Ken Croker, VP

How the VIX is Calculated

Level: Advanced

Overview

The VIX (Volatility Index) is a benchmark of implied volatility for thirty days in the future. It was created by the Chicago Board Options Exchange, or CBOE, in 1993. This article will focus on what the VIX is, how it is calculated, and how it can be applied. This is a concise version of CBOE’s white paper report for the VIX, which is quite a long and mathematical read.

What is the VIX?

The VIX is a measure of implied volatility in the market. Implied volatility is simply the expectation for how much an underlying asset will move within one standard deviation.

The VIX originally was calculated based on the S&P 100 index at-the-money calls. However, it was revised a decade after it was introduced so that it was based on a wide range of strike prices for options on the S&P 500. We will be focusing on the newer calculation method.

VIX Formula

This is the formula for calculating the VIX:

σ is the VIX/100. That means that the VIX is σ * 100. Notice that the formula gives you the square of σ.
T is how much time there is until options expiration. More on this below.
∑ means summation (addition many times, don’t be scared). The i underneath means that i is a variable within the summation.
F is the forward index level. This is basically what people are predicting the S&P 500 index will be at in the future, based on options prices.
Ko is the first strike below the forward index level.
Ki is also a strike price, but of the ith out-of-the-money option. Remember the summation? For each value of i, Ki will change too. Ki is the strike of a call option if Ki is greater than Ko, a put option if Ki is less than Ko, and if they are equal it is the strike of both the put and call.
∆Ki is just the interval or difference between strike prices around Ki.
R is the risk-free interest rate until expiration. This is not determined by options but rather by bonds. This is for the U.S. Treasury Bill maturing closest to the options contract.
Q(Ki) is the quote or the price of the Ki option. It is the average of the bid and the ask.

That’s all! The raw equation is quite simple, but some of the values used in the calculation require more in-depth analysis.

Keep in mind that the VIX measure expectations for 30 days, or a month, in the future. The time to expiration is calculated as follows:

T = {M_(Current day) + M_(Settlement day) + M_(Other days)} / Minutes in a year

M_(Current day) is how many minutes are left until midnight today.
M_(Settlement day) is how many minutes are from midnight on the settlement day to 8:30 AM for standard options, and till 3 PM for weekly options.
M_(Other days) is how many minutes are in the days between today and expiration

As we can see, T is just a fraction of the year representing how long it is until settlement of a contract.

VIX Calculation Process

This information is a simplified version of CBOE’s white paper on VIX calculation. The steps CBOE uses to calculate the VIX figure are outlined here:

Select the options to be used in the VIX calculation. For EACH month:
1. Take the the strike price at which the difference between prices for calls and puts is the smallest (price is the average of bid and ask). Do this for both the near term (or current term) expiration and the next term expiration.
2. F = Strike Price from above + e^(RT) x (Call Price – Put Price). Recall that this is the forward index level, or F. You will get F1 for the near term and F2 for the next term options.
3. Take Ko as the strike price below F. You will get two of these for each value of F: one for the near term, one for the next.
4. Start iterating through the put options with strike prices less than Ko, and go down from there. Skip ones with bid prices of zero. If two consecutive strikes have bids of zero, stop. Select all of the options iterated through here for use later.
5. Start iterating through the call options with strike prices greater than Ko, and go up from there. Skip ones with bid prices of zero. If two consecutive strikes have bids of zero, stop. Select all of the options iterated through here for use later.
6. Select both the call and put with strike Ko. This will be treated as a single contract in the formula, with the prices for the call and put averaged.
Calculate volatility or the σ values using the above formula for both near-term and next-term options (these are the contracts and values calculated in the outer step 1). The weighting of any contract to the VIX value is proportional to ΔK (the difference between strikes) and the price of the option. It is inversely proportional (negatively affected by) to the square of the option’s strike price.
Calculate the 30-day weighted average of σ1 squared and σ2 squared. Square root that value and multiply it by 100 to get the VIX (look back at the VIX Formula section).

How the VIX is Used

The VIX itself is just a number used to gauge the amount of “fear” in the market. The nature of the VIX’s usefulness arises from the formula above, and is essentially provided by looking at how much people are paying for options (protection) from a market move. In terms of raw values, values above 32 are times of fear, and options pricing is generally more conducive toward premium sellers. On the other hand, values below 16 reflect a calmer market in which premium buyers get a better deal.

Over the years, the VIX has evolved from being just a number. Futures on the VIX index itself trade also, and multiple ETFs are plays on where the VIX will move.

Summary

The VIX is a powerful tool that uses a simple formula to calculate the amount of “fear” in the market. Although the raw calculation process is a bit dreary, understanding it will allow you to realize from where the VIX derives its meaningfulness. Of course, computers now track the index and its value is widely accessible on the web. Hopefully, this article has provided you insight on the inner workings of the CBOE Volatility Index.

Volume

Level: Beginner

This is a beginner level education blog, which means that this is a topic that is introductory and has been covered by our club long before. These should be review and an easy read. Intermediate level articles might contain content intriguing to officers, but not too advanced topics. Advanced blogs are reserved for Michael Trehan for now.

Volume is a powerful tool used by many technical analysts to measure other traders’ level of interest in a particular stock. In addition, it can be used to confirm trend continuations or reversals. It is calculated as follows:

Volume = Shares Traded / Time period

Now let’s further simplify some of the terms here.

Shares Traded: The number of shares that were either bought or sold (it does not matter which you use, the number will be the same) throughout the time period
Time Period: The amount of time being tracked (e.g. 1 hour, 1 day, 1 week)

For example, if 5,000,000 shares of ABC were sold over the week, then its average volume for each day would be 1,000,000. Keep in mind that the number of sellers must equal the number of buyers. If it does not, the price will move up or down until it does.

Technical analysts regularly use volume to determine the strength or weakness of a market move. As an example, one day XYZ shares increased considerably. If the volume for that day was high, it means that tons of buyers wanted the shares. This buying pressure created a strong uptrend which was difficult for bears to fight. However, if the volume was low, it means that buyers did not want ABC shares that badly. The only reason the stock moved up that day was because there were few sellers to keep the price down. This created a very weak trend which could easily be reversed if some sellers enter the market. With this in mind, several events can cause tremendous buying or selling pressure: an earnings report, a manufacturing recall, etc. This pressure then causes the volume to spike.

Many websites like FINVIZ and StockCharts automatically display the volume when a ticker is viewed. The volume appears as a bar chart at the bottom of the display. In addition, the volume bar will be either green or red, depending on the performance of the underlying stock that day.

-Ken Croker

Greeks

Level: Intermediate

I will be bringing you more advanced education blogs that are outside the scope of the club currently.

What are your Greeks? Take a peek.

Delta: Your option price moves by DELTA amount for each dollar the underlying moves. However, even delta can change…

Gamma: Your DELTA moves by GAMMA amount for each dollar the underlying moves. This is the derivative of DELTA.

Vega: Measures how much the option price moves in relation to volatility.

Theta: Each day, how much your option price decays. This could be good or bad depending on whether you are a buyer or seller.

Rho: How much the option price is affected by interest rates. Not that commonly used.

Use these in conjunction with implied volatility and theoretical pricing tools like the Black Scholes model (more on that later) for the best success in choosing strike prices and expirations.

– Michael

What is a Moving Average?

This is my first minute blog, which should take you under a minute to skim. Enjoy.

A moving average is an indicator that smooths out the bumpy chart you usually see. It works like this: You take the close prices of the last # days (e.x., 50) and average them. You then plot that number for each day. That’s a simple moving average. Exponential moving averages weight recent close prices more heavily.

Moving averages of different lengths can be used together to create more advanced indicators, which we will cover later.

– Michael