Showing posts with label python-options-trading. Show all posts
Showing posts with label python-options-trading. Show all posts

THE OPTIONS COURSE- OPTIONS AND THEIR BUILT-IN SENTIMENT INDICATORS

THE OPTIONS COURSE


OPTIONS AND THEIR BUILT-IN SENTIMENT INDICATORS

The utilization of sentiment indicators has been common in the stock, futures, and options market for a long time. However, the difference for the options market is that it inherently possesses its own sentiment indicators and does not have to look outside to gauge or measure investor feelings. The inherent sentiment indicators I am referring to come in the form of implied volatility, option trading volume, option open interest, and put/call ratios. All of these reveal important sentiment type information about the markets. First, implied volatility is a calibration of a stock’s volatility as implied by the current price of the option. Many times it is referred to as the fear factor as it gauges the level of concern investors might have in the markets at a particular time. 

An option’s implied volatility is an approximation of the underlying equity’s volatility in the future. Estimating the level required to arrive at the option’s current value gives us implied volatility. To determine whether implied volatility is exhibiting investor fear or complacency, we compare it against its historical volatility levels. Historical volatility, also known as statistical volatility, gauges a stock’s volatility based on the equity’s past price action. Historical volatility is constructed using the standard deviation of a stock’s price changes from close-to-close of trading for a specified time period. If an option’s implied volatility is greater than the statistical volatility, the option is considered expensive or overvalued. The type of sentiment reading would indicate to the option strategist that they should consider selling options. 

If an option’s implied volatility is less than historical volatility then the option is considered cheap or undervalued. In this scenario, the options trader would pursue a strategy where he or she would buy options. This comparison is necessary because just relying on implied volatility alone doesn’t really provide you with enough information. Additionally, there are two other perplexing ways to use options for ascertaining investor sentiment: option trading volume and open interest. Option trading volume is the amount of option contracts traded in one day recorded at the market close. The interpretation is based on the idea that put purchasing is bearish and buying calls is bullish. Put volume divided by call volume determines if a specific market has a bullish or bearish sentiment.

Option open interest is the number of outstanding contracts that are available on a specific option series. Monitoring the open interest statistics of an option allows an investor to judge the relative demand of an option. An increase in an option’s open interest means there are additional purchasers for that option. On the other hand, a reduction in the open interest of an option indicates fewer buyers and more sellers than previously. Just as with option volume comparing the put option’s open interest with the call option’s open interest generally indicates the underlying equity’s bullish or bearish bias. Finally, you can look at how bearish or bullish a particular market is by monitoring the ratio between put premiums and call premiums. This is by far the most popular option sentiment tool of the mix. 

In general, if there is a lot of put buying compared to call buying the premium on puts will be higher, which signals a bearish environment. Conversely, if call buying exceeds put buying, this increased demand pushes call prices higher signaling a bullish sentiment. These inherent sentiment indicators are yet another illustration of the amazing flexibility of an option. One thing to note though before employing the indicators as definite buy and sell signals: Sometimes an upsurge in open interest can be attributed to a large institution hedging a position. As with any technical tool, look to get confirmation from one or two additional indicators before locking yourself into a directional bias.

VIX AND VXN

The Chicago Board Options Exchange created the CBOE Volatility Index, or VIX, in 1986. VIX has become the number one gauge of market volatility available today. Computed throughout the trading day, it is unique in that it offers up-to-the-minute or real-time information regarding market volatility. Therefore, there are no cumbersome calculations and the information is available at the click of the mouse. VIX gives up-to-the-minute readings of market volatility. At the same time, it is not a gauge of actual volatility, but a measure of implied volatility. Implied volatility is derived using an option valuation model. In the case of VIX, the options are on the S&P 500, or SPX index, which is an index of 500 large companies with stocks trading on the U.S. exchanges. 

Therefore, VIX represents the market consensus view regarding the future volatility of 500 of the largest and most actively traded stocks. So, as VIX measures the implied volatility of SPX options, it will begin to rise when traders expect volatility to increase. During times of uncertainty and market turmoil, VIX will move higher to reflect expectations regarding future volatility going forward. For that reason, it is often referred to as the “fear gauge.” However, during times of relative tranquility in the U.S. stock market, VIX will move lower to reflect investor expectations that market volatility will remain low. During the fifth year, beginning in March 2003, the market performed well and stocks moved broadly higher. 

During that time, the CBOE Volatility Index edged lower. In fact, VIX fell to seven-year lows of 14.3 percent in early 2004. There was no fear reflected in the market’s “fear gauge.” Another interesting aspect of the chart is the periodic spikes in the volatility index. This happens during periods of panic in the market. For instance, shortly after its inception, during the market crash in October 1987, VIX hit a record high of 173 percent, which has never been surpassed. In the mini-crash of 1989 after the problems associated with UAL and its restructuring, VIX spiked again. In 1990, when Iraq invaded Kuwait and the United States became embroiled in a war in the Middle East, the volatility index spiked twice: once when Iraq moved into Kuwait in 1990 and again in 1991 after the United Nations attacked Iraq.


FIGURE  CBOE Market Volatility Index or VIX 

More recently, in October 1997, investors were spooked when the Dow Jones Industrial Average tumbled 555 points. VIX jumped to 55.5 percent. In the fall of 1998, as the impact of the global financial crisis was beginning to shake U.S. markets, market anxiety once again picked up. The volatility index soared above 65 percent in October 1998. On the chart, we can see VIX spiking again in September 2001 when the terrorist attacks rocked the financial center on Wall Street. Since that time, VIX has traded below 50 percent. In response to the growing interest in Nasdaq 100 options, the Chicago Board Options Exchange launched an implied volatility indicator on the Nasdaq 100 Index in January 2001. 

Known by its ticker symbol, VXN, the new implied volatility indicator was created to track the implied volatility of the popular NDX options contract. Like VIX, it is updated continually throughout the trading day. In addition, traders can also plot the index’s long-term movement in order to identify the extremes. However, there are times when it spikes higher, like in September 2001 and July 2002. A move higher in the Nasdaq volatility index tells us that the implied volatility of Nasdaq 100 Index options is on the rise. Therefore, traders are expecting market volatility to increase going forward, which generally occurs when investor anxiety levels and fear are on the rise. Using VIX and VXN as sentiment indicators requires a bit of contrary thinking. 


FIGURE  CBOE Nasdaq Volatility Index or VXN 

An adage among options traders says, “When VIX is high, it’s time to buy. When VIX is low, it’s time to go.” This tells us that when VIX is high, it is time to buy into the stock market with long strategies such as bull call spreads or other bullish strategies. During these times, market anxiety levels and pessimism are high. In that case, investors, or the crowd, have probably overreacted and driven stock prices to bargain basement levels. When VIX is low, it is time to go, or get out of the market. During those times, investors are probably complacent or too bullish on the stock market. So the contrarian thinker will get out of bullish positions, or even set up some bearish trades.

A NOTE ON BEING A CONTRARIAN

Taking action contrary to the crowd will always feel uncomfortable. At the actual time you must decide and act, you will never have all the information you’ll want because gauging market psychology is more of an art than a precise science. Furthermore, your countertrend decision will make you feel lonely, and we humans are social animals who seek comfort and approval from others. Always remain tight-lipped about your investment moves. If you’re a talking contrarian, people hearing of your views and behavior will exert immense pressure and may convince you to abandon your thinking at precisely the wrong times. Successful trading, contrarian-style, requires observation, understanding, and, finally, action. 

First, you must see facts: events, trends, and rates of growth or decline. It is imperative that the contrarian trader develops a sense of history, an ability to put things together in context, and a good feel for when a trend is moving to an extreme. But even all that will do you no good if you don’t take action. Acting is usually the most difficult skill to master. Being a contrarian requires that you identify the market’s situation, whether that be broad averages or the market of opinion. The factual and emotional states of the economy and the market can be observed at any time. Successful investment behavior requires patience so that you don’t pull the trigger at the very first observation of important elements; you need to wait for an accumulation of evidence that an extreme is developing.

Trying to play contrarian on a short-term basis creates what is known on the street as whipsawed traders. Given that the public is usually right during the trends but wrong at both ends, we should not get impatient at the first sign of extreme behavior in others. Let a trend run for a while and watch the evidence accumulate. This approach can be profitable due to the bipolar nature of market dynamics. The trick is to recognize a market’s turning points by monitoring psychological market indicators to assess your next move and then trade with or against the majority’s view of the market. One indicator alone, like VIX, will not necessarily help you time the turning points. To invest contrary to the crowd, you need to consider a broad range of indicators, the big picture, and sometimes exercise a great deal of patience.

NONANALYTICAL METHODS

There are many other ways to find a good investment. However, the two most common are probably the most unreliable. It is important that you use discretion as you make investment decisions.

Reliance on Others

The biggest mistake most people make in the field of investing is relying on others. This includes consulting brokers, listening to friends, receiving tips, or even calling psychic hotlines. Professional money managers (mutual fund managers) also must be selected with care. Be careful whom you listen to. You are the only person who is ultimately responsible for your own profitability. Make a strong commitment to relying on your own initiative.

Religious Experience

From long observation, it seems to me that prayer is truly the method most often used by traders and investors. Most traders and investors do very little analysis and have no idea as to what is going on; still they go ahead and trade. Then, they just pray that they will be right. Even when their initial position goes against them, they just stay in the bad trade praying the market will come back. They continue to pray until they can’t take the loss anymore or they lose all their money. Nick Leeson, the trader who allegedly lost $1 billion for Barings Bank—a loss that brought down the 200-year-old institution—got himself into a bad position and kept adding to that bad position praying that the market would indeed turn around and make him right. It never happened. Seize the day!

CREATING A TRADING FILTER

After years of investing and trading, I came to the realization that to become good at this business I had to keep my eyes and ears open. I then set myself up to be able to accept both visual and audio information and to filter out useless information. Peter Lynch, former manager of the Fidelity Magellan mutual fund, is one of the best money managers of our time. In his books, he clearly states this principle of accepting all available information. Although the Magellan Fund, like many other funds, focuses on longer-term investments, the principles stated in Peter Lynch’s books—as well as books by other great investors—can also be applied on a short-term trading basis. 

I focus my attention on these principles of “intelligent investing” to get both the long-term and short-term perspectives. Many investors may be satisfied with a 10 percent return on their money compared to 4 percent interest for a certificate of deposit. I prefer to work a little harder in order to get a much higher percentage return. After all, this is the business I choose to be in. I want my trades and investments to make me a very good living no matter how much money I started with. Remember, the only way to build your account up quickly is to spot the consistently profitable opportunities and to use your money efficiently. 

Most investors and traders have very little idea how to find explosive opportunities. It’s not that they’re not smart enough. It’s just that they haven’t been made aware of the effectiveness of these techniques. During each trading day, I can work as little as five minutes and still make more money (with a much higher return) than investors who work all day. This is not to say that I spend only five minutes a day trading. I enjoy this business way too much. In fact, I don’t even see what I do as work. I am sometimes even a little disappointed when the trading day is over. Believe it or not, weekends can be my most difficult periods. 

However, explosive opportunities can be found every day. To gain true opportunity insight, open yourself up to receive information from the perspective of a trader. Don’t let important information slip through your fingers as many people do. Filtering information correctly can be the key to making money. Years of experience have shown me that the mega-successful investors are unique individuals who have developed approaches to finding opportunities others may be missing. Let’s take a closer look at where these chances to make a very high return on your money in the short term—minutes, hours, or days—can be found.

Remember That Stocks Follow Bonds

If you keep your eyes on how interest rates are moving, you can determine where shares are likely to go. When interest rates are going up, bond prices are going down and shares will likely go down also. Conversely, if interest rates are decreasing, then bond prices are rising and shares should also be rising. If interest rates are stable, shares will have a tendency to go up. You can use these insights to create consistent profits in your account. However, there are points in time when this relationship does not hold. When this occurs, take the time to discern what has affected this relationship. For example, in 1998 turmoil broke out in the Asian markets which changed this relationship. Foreign investors bought bonds, which increased the price of bonds and lowered yields while the stock market moved downward.

Stay Informed on Seasonal and Event-Driven Markets

Event-driven markets are exactly that: markets that are driven by events—seasonal, political, or otherwise. For instance, the energy markets are seriously affected not only by war in the Middle East, but by scheduled meetings of the Organization of Petroleum Exporting Countries (OPEC). The agriculturals are directly impacted by seasonal weather changes. Bonds are tied to changes in interest rates and the monthly release of the government’s unemployment report. In essence, look for markets that have an event that triggers a specific trade strategy once or twice a month, or maybe once every three months.

To keep up with these important market factors, you must keep abreast of daily news by watching television and reading mainstream and alternative newspapers and magazines in hard copy and on the Internet. It can also be important to listen to what key people in specific markets have to say. Typically, you need to come home from work and study what the markets are doing from many angles. In the beginning, it can be empowering to keep a journal of daily events and their effect on various markets you are actively watching. 

If a market’s going to move, then it’s more likely that you can make money from it. By studying the daily reactions of specific markets to events, you can begin to forecast which strategy can be used to make the largest potential profit. Always keep an eye on markets that are dependent on the weather (oil, soybeans, wheat, etc.). See how they are reacting to seasonal factors. The tougher the winter, the higher the price of heating oil. The longer the drought, the higher the price of soybeans. All of this information can be used to find highly profitable trades.

Walk around Retail Stores

You can even make money while you are spending it. Just open your eyes and ears when you are shopping and see if you can spot an interesting investment.

• Find out what products are hot.
• Notice which products have the most store shelf exposure.
• Ask a clerk which products are literally flying off the shelf.

On a shopping trip to a local toy store at Christmastime, I noticed that not only was the store filled to capacity, but people were fighting over the last items of one obviously hot product. Instead of jumping into the battle to fight for a toy, I picked up a box to find out the manufacturer. In addition, I asked a clerk at the store about the frenzy over this one product. 

She stated that this was almost a daily occurrence and then told me about a number of other items that were also flying off the shelf. This is not to say that everyone will be this helpful, but I was able to spot some particular potential investment opportunities by just asking questions of a store clerk. I then called my broker and investigated whether these particular companies were doing well. The next time you are shopping, take a look around and see if you can spot hot products or hot companies.

Look for Opportunities When Driving

Even when you’re driving your car, you can spot opportunities. Once again, all you have to do is keep your eyes and ears open. For example, a few years ago I found a new restaurant—at least it was new when I found it—by the name of Boston Chicken. I first visited the place because I was hungry. However, when I saw the food and tasted the meals, I realized that this was a different kind of fast-food restaurant. I was given large portions of delicious food at a good price. I was not only satisfied with the food quality, but I felt that I got a good deal as to price and quantity as well. I returned on several occasions with others and everyone had the same impression. In addition, the counters displayed information on franchise opportunities. 

Although I was not interested in becoming a franchisee, it was clear this concept had to take off. Sure enough, these restaurants started popping up all over Boston, and the list of franchises exploded nationwide. When the company went public, I knew I had to get in on this. The company’s public offering was a smash success. Now the company is known as Boston Market with stores all over the country and entrĂ©es in supermarkets as well. When driving, always look for trends. Years ago I spotted a number of cars and trucks that had some interesting designs. It surprised me that they were Dodge products—I had never been a big fan of Dodge or any U.S. manufacturer’s automobiles. However, I kept seeing television commercials about the “new Dodge.” 

Well, I knew the old Dodge was not very exciting; but as a car fan—I love sports cars—I kept reading about their newest “super car,” the Dodge Viper. Luckily for me, a friend ended up buying one and I had the privilege of driving the Viper in the Nevada deserts. If you’ve ever driven in the desert, you know you can drive really fast out there. After all, there’s nothing there but hard-packed sand. I won’t tell you how fast I was going; but I was beyond merely being impressed with this car. At that time, I owned some other sports cars (Porsche and Ferrari) but I found the Dodge Viper to be much more exciting and fun to drive. Thereafter, I sold the Ferrari and bought the Viper, remaining to this day one of the Viper’s biggest fans. 

Years later, I still get a thrill out of driving this car and so does anyone I know who drives one. It is by far the best sports car I have ever owned. This very positive impression of the car—a Chrysler product—led me to change my opinion of Chrysler products and American automobiles in general. Since then, I have bought two other Chrysler products (Jeep Cherokees), and I love them just as much. Such a positive experience on my part and the number of Dodge Ram pickups I saw on the road led me to believe that Chrysler had nowhere to go but up. The company has since reported record earnings. Indications are that this trend will continue and the stock will be a good long-term investment.

Critique That Which You Already Own

If you like a certain product, others probably do also. You can then look at this product as a potential investment. In addition, if you have a problem with a product and you feel dissatisfied, then others will likely have the same opinion. This may be a good selling opportunity for the stock (using a strategy that makes money when the price drops). Most of us have had a lot of both good and bad experiences. It is up to you to figure out how to translate these experiences into profit opportunities. If you buy an item and then are dissatisfied, can’t get anyone to help you, or can’t exchange the product, you’re probably not the only one. This happened to me recently. I kept hearing about a certain computer product and how great it was. 

I subsequently purchased it and found installing it to be extremely difficult. The product was supposed to be easily installed, especially for a computer-literate person like myself. I contacted the customer support line and was put on hold for 20 minutes. I hung up out of frustration and called a second time determined to get through. After being kept on hold for 45 minutes (a very expensive long-distance call), I finally got a representative who knew less about the hardware and computers than I did. I asked for someone else, who ended up giving me information that crashed my computer. I quickly returned the product and went back to a reliable company that I have never had any problems with—Hewlett-Packard. 

I figured that everyone was having the same problems I was and that the product would flop as the hype about the product fizzled. The stock of this overhyped company was trading at around $50—it had made a very fast move up from around $5 in less than a year. I immediately put on a bearish position to make money when the shares went down. The shares fell in less than four months to around $15, and I smugly changed my dissatisfaction and frustration with the company into cash. All I had to do was translate a personal experience into what other people’s experience was likely to be and pinpoint a way to make money from this information. You can do this on a daily basis with items you own or have purchased and returned.

Ask Your Children

Yes, even children can be a good source of spotting new trends. What new movie do they want to see? What new toys do they want to purchase? What clothes styles are all the rage? What sports are popular? Children offer a wealth of information especially because they are greatly influenced by what other kids are doing as well as by what they see on television, in the movies, or anywhere. They can alert you to new trends that can affect the bottom line of a company. These pieces of information are valuable to the establishment of a winning investment perspective.

Look Around Where You Work

Opportunities can also be spotted directly from where you work, your spouse works, or a friend works. For example, a friend of mine who was working at a pharmacy told me that one of her favorite customers sadly has AIDS. One day, he came into the pharmacy looking much better. He credited a new experimental drug from a company called Nexstar Pharmaceutical with helping him feel better than he had in years. My friend had an article from the local newspaper that her customer had shown her (he was mentioned in the article). 

I called my broker to ask about the stock. It was trading around $9 a share. I bought some shares in the company and within a few months it was well over $20 per share. (I’ll give my friend credit for this one.) I sold the shares for a large return, and now I keep asking pharmacists what they consider to be exciting products. By going directly to the people who know a lot about a particular industry, I can leverage their years of education and experience into another profit making opportunity.

Subscribe to a Data Service Provider

Data service providers can furnish you with current prices on shares, futures, and options. In addition, you can receive up-to-the-minute news and market analyses. This information comes in a variety of ways, including the Internet, cable, FM radio, satellite, and wireless networks, and can receive price quotes that are real-time (as the prices change on the exchanges they are transmitted to you), delayed (typically 15 to 20 minutes after the prices change), or end-of-day (after the markets close). Your service fees are based on the kind of service you choose to receive. 

The faster you get your data, the more costly it will be to obtain; however, it will also be more accurate for making your investment decisions. If you are not going to sit in front of a computer all day long, then you don’t really need real-time feeds; you can easily get away with delayed or end-of-day quotes. Subscribing to only what you need keeps your cost as low as possible—you can upgrade later as your trading progresses. Depending on the data you want and the exchanges you sign up to, data feeds can cost you from $20 to $400 per month. There are even feeds used by the large institutional firms (big trading firms) that can run thousands of dollars per month. 

If you want to place longer-term trades, delayed or end-of-day quotes should be sufficient for your needs. In many cases, if you sign up to trade with an online brokerage firm, they will provide real-time quotes for you at no cost or for a very small fee. Remember, if you are just starting out, keep your overhead as low as possible. Request information on only the markets you initially want to trade. Too much information can be overwhelming if you don’t know how to use it. It is essential to start small and build your profits systematically. A detailed account of data providers can be found in Appendix A.

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