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Good job reading both threads. You will probably have much success as a trader because you put in the effort to research. research, research. There are no shortcuts to being successful.
Trading: Primarily Energy but also a little Equities, Fixed Income, Metals and Crypto.
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I think there's also a burn-out factor. If your an experienced trader and participating here to hopefully learn some new things, but to also give a little bit back and help others, there are only so many times that you can answer the same question before it becomes very mundane.
Hi, I have few questions regarding options on futures in general:
1. I see that when saying volatility, it may mean 2 things: volatility of the option itself or volatility of the underlying. I have not been following closely the volatility of the option itself, but mainly just of the underlying for the trading. Im not an expert about Black Sholes model, but when calculating prices of options on stock they use volatility of the stock (underlying), so I assume for commodity it is the same thing too right? That means when volatility of the underlying spikes, the option on that commodity will explode in prices, right?
For example Nat Gas during Nov 2018. Volatility of the underlying March 2019 contract went up to 100% levels, and prices of options exploded. I understand that when option prices went way up that mean volatility of the options go up too, but is it important to watch it closely? OTM options have pretty good chances of moving pretty wildly, so I guess options volatility shouls be much higher than of underlying, is that correct? (options doubling or even trippling is not rare, so volatility during those time must be 100-200% right?)
2. When market opens and we see bid-ask spread for options, it is set by market makers right? How do they determine whats fair starting point, using Black Sholes? Then how come supply/demand of traders come into determining the prices of options? For example according to Black Sholes, the price specific Corn OTM call is just 16 ticks, but traders have a view that Corn will soon surge for some reason and they bid it higher and higher till 20-25 ticks, is that normally how prices are determined/changing?
Trading: Primarily Energy but also a little Equities, Fixed Income, Metals and Crypto.
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It's the volatility of the underlying. Very sophisticated traders may also look at the volatility of volatility (for example there are options on the VIX which itself is a volatility index) but that's definitely not a basic strategy.
NatGas is kind of an anomaly. Very few markets behave and move like it does. (Electricity is even worse).
I'd advise not to think like that. Think about is an option on the underlying.
Black Scholes was the first closed form option model. It has an underlying assumption that returns are log normally distributed. This is not the case as the tails are much fatter in financial markets. You can still fit a Black Scholes model to a market, but when you do that you normally find that volatility has a 'smile', meaning volatility is higher for out of the money options. This is how a model that assumes log normal returns fudges for fat tails. There is also a supply-demand element. If everybody thinks the market is going up, Calls will get bid and Puts will get offered. Markets are also not symmetrical. They move differently when going down than when up. The combination of these factors create situations where NatGas Call Option Implied Volatility is significantly higher than for puts in the winter, and why Equity Index Put Implied Volatility is higher than Calls.
Market Makers are normally trading volatility and not price. They'll buy or sell anything and immediately delta hedge it, leaving them with cleaner Volatility/Vega risk. Then it becomes an issue of how actual volatility plays out in comparison to the implied volatility traded.
Thank you for your response, that clears a lot of things. Through out the thread I see lots of people mention "options volatility explodes" or "historcal volatility of options", I was kinda confused because while volatility of options itself is important, Id want to focus more on volatility of the underlying.
That brings another question - selling NG calls during winter time. Everybody knows what happened to James Cordier last winter, and I see many experienced traders here fought and lived through winter 2013-2014. I want to share my experience last winter:
Last September, as a novice trader I sold NG Dec calls at strike 4. Underlying at that time was around 3. I didnt know much, just thought the premium is really nice and the strike is "quite far away". I havent research much at that time but I checked EIA and saw that storage is below average, but thought Id try the trade (my 3rd trade with real money). In matter of weeks, that option quickly doubled, and I was disciplined enough to exit. I learned my lesson: do not selling against fundamentals and without clearly understanding fundamentals. I repeated the same mistake in coffee and sugar not long after that (and lost money), but I guess thats my learning curve. I decided to forget about NG.
Then at the beginning of November, I started seeing NG futures are moving very wildly. I remember looking at Calls nearly 200% OTM, with very high premium and premium/margin (even for IB!). That was very tempting but fundamentals were bad, and I see that not too long ago NG did approached close to those strikes (around 7-8), so I didnt act on it.
Then around 14-15th November, on the day NG futures spiked 15-18%, I saw that NG Calls with pretty ridiculous strikes were very expensive, with margins really low compared to premium, so I decided to sell a little. Things got pretty crazy. First 1 sold 1 Call with strike 12 (I think it was the most dangerous March Call, I didnt know it back then). It doubled in value in just hours, so I sold another one. The day after that I sold another 1 at strike 17. I tried to be as cautios as possible, kept position very very small margin wise, and I believed that NG will not reach those level. The margin requirement for those trades was very low, but I also did set aside a lot of cash excess for those (6-8xIM), however the premium received was huge (in magnitude of 8-9% of net liquidation value). 2 weeks later when things more or less calmed down, I sold another NG Call at strike 17.
I have my own formula regarding calculations of ROI (something similar to Ron's), and those calls brought a ridiculous ROI compared to my average trades! In the end all of them expired worthless.
Later I thought a lot about what happened. I read that selling NG calls during winter is suicide. I think I was lucky, but I also think every once in a while opportunity does come, and maybe we can take the risk. I did my research, and saw that NG futures winter contract increase in volatility during winter. Sometimes it is to 40-60%, sometimes to 80% and in this case was over 100% (Sorry if numbers are not exact). And someone pointed out that about every 5 years, NG volatility spikes to these levels (there was a nice historical graph). James Cordier sold NG Calls when volatility was not yet this high, and thats what got to him. So I was thinking, while its very difficult to time the trade, every year we can sit and wait for the opportunity. If volatility ever reaches 60-80%, maybe we can take a small position. Or to be safer, wait till it gets to 80% or above to take position. The key here is to be patient, and to take a very very small position. If that year volatility doesnt even pass 50%, then just forget about it. The strikes should be far enough away, something historically high. You may not get the trade every year, but when opportunity does come, take the risk. Last year the selling window lasted for a few weeks!
That was my experience with NG. I know I may sound naive here, so Im eager to hear what you guys think about it. I also remember SMCJB wrote that short NG calls during winter is very risky, not stupid but risky (which comes with high reward), and at one point in the past that "gun to the head, buy or sell NG calls, I choose to buy"
P/S: In the book, I think Cordier once said he was able to sell NG calls at strike 34 during panic sometime in the past. Ironic and sad how he also got burned by something similar.
For me there are three simple rules in trading of Natural Gas options:
1. Do not sell options on Z, F, G, and H contracts.
2. Do not sell options on Z, F, G, and H contracts.
3. Do not sell options on Z, F, G, and H contracts.
As you might hve read in the energy thread, I begin to buy (!) some calls for the NGH future.
Trading: Primarily Energy but also a little Equities, Fixed Income, Metals and Crypto.
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Don't apologize. Nothing to apologize for. I was just making a joke!
There's obviously a place for analysis and modelling but I generally agree with you that simple is better, and definitely think that too many people over complicate things.
For what its worth while I do own the book - I haven't read it either!