The Devil is in the Details

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The devil, as they say, is in the details. Nowhere is this saying more applicable than in the intricate world of options trading. Every product has a host of arcane details that must be analyzed before an effective trading strategy can be developed. While there are some time-honored strategies that can be applied across a broad spectrum of options, their performance will vary wildly depending on the intricacies of each product.
Analyzing and capitalizing on these intricacies can seem like a daunting prospect to both new and experienced traders alike. However, with a little attention to detail, you can swing the odds dramatically in your favor.

Traders tend to be creatures of habit. When they find a technique or strategy that works in one option product, they usually stick with it when trading a new product. Time and again, these traders are disappointed when the new product doesn’t perform up to their expectations. With some careful analysis, though, you can avoid this all-too-common pitfall. The analysis of any new product should begin with a study of its volatility skew. This may sound straightforward but, unfortunately, it is not.

Far too many traders simply plug the implied volatility levels into their models without ever attempting to determine the reasons behind those levels. Studying a product’s skew involves more than just fidgeting with the call and put wings so that they fit into  the parameters of your model. It also involves an analysis of the product’s open interest, trading history, customer base, contract volume and a host of other factors. The onset of multiple listing has made some of this research difficult, but the effort is worthwhile if you wish to avoid costly mistakes in the future.

For example, the skew of a small, highly volatile technology stock will be similar to the familiar “smile” pattern. A trader who has had success trading that specialized skew pattern might be tempted to try the same techniques when trading a larger, less volatile equity option. However, he will undoubtedly discover, much to his dismay, that skew trades such as call spreads, put spreads and risk reversals do not perform the way he expected. An analysis of his new product’s skew would have saved him a great deal of money and aggravation. This analysis would have shown that, while every option’s volatility skew is different, the skews of large companies like DOW and S&P 100 components tend to share a few performance characteristics.

These stocks are widely held and it is common for mutual funds and large investors to sell tens of thousands of calls every month to lock in profits on their massive equity positions. It is also common for these same funds to buy large quantities of puts to hedge their portfolios against adverse market swings. This regular hedging activity has a marked effect on the volatility skews of these products. The premiums in the call wing are depressed while the premiums in the put wing become inflated. A trader should study the performance of this skew before developing a trading strategy. Otherwise, he might find himself selling skew (short the put wing, long the call wing) in an environment where such positions are rarely profitable.

Another important detail of an option product is its term structure. Experienced traders develop an almost innate knowledge of their product’s term structure. They know instinctively when volatilities are within their normal parameters and when they are significantly inflated or depressed. Such knowledge is necessary for understanding and predicting the performance of complex positions such as time spreads. Most traders think that a careful study of historical volatility charts is enough to familiarize themselves with a new product’s term structure. While studying charts is an important step, it is not the only one. Traders must also familiarize themselves with the minor details of the product. Earnings announcements, analyst conference calls, mutual fund redistributions, company mergers, stock splits and a host of other factors can have a tremendous impact on a product’s term structure. A wise trader will incorporate all of these factors into his model before planning his trading strategy.

Term structure and volatility skew are just two of the many details that must be analyzed before trading a new product. The more intricate and exotic the option, the more study and analysis is required before a trader can develop an effective trading strategy. Index options, for example, offer a host of different complexities from equity options. Most index options operate on the European expiration schedule while most equity options operate on the American expiration schedule. The product’s expiration type will have a significant effect on trades such as deep put spreads, deep call spreads and boxes, just to name a few. Also, while equity options are hedged with their underlying, index options are hedged with index futures or stock baskets. These hedges are often imperfect and require frequent adjustment to match the fluctuations in the option position. It is also important to keep in mind that, while stock hedges do not expire, index futures have a definite expiration date that may or may not correlate with the expiration date of your options. Index option traders routinely have to roll their hedge positions forward by trading futures spreads. A new index trader who fails to calculate the proper hedge for his options, or one who forgets to roll his hedge position forward before expiration, will not be long for the trading pits.

As this brief review has shown, every option product has a host of intricacies and complexities that must be understood before an effective trading strategy can be developed. Failure to study these intricacies can spell disaster for even the most seasoned trader since, when it comes to options, the devil truly is in the details.

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