Option Volatility vs SPX Price Action

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

Quote of the day:

"The only thing we learn from history is that we learn nothing from history"

As Georgie boy so cynically elucidates, despite the lessons that can be learned from studying history, humans continue to make the same mistakes over and over again. We do not truly learn from the past, and we are doomed to repeat it.

Not today, you poofy hat-wearing 18th century German philosopher...not today!!

We are going to review SPX price movement as it relates to the all-powerful BANG and find some actionable relationships to look for as we trade!

BANG for Your Buck:

In the coming week, this section will be beefed up with even more relevant and actionable data such as: weekly bang review, overnight expectations, gap probability analysis, and more! Believe it or not, the market just kinda tells you all this stuff, if you know where to look...

Now let's analyze what the BANG told us last year and find some insights to improve our intuition about price action!

2022 - BANG vs. Price Action

Here at the Jumping Cholla, the BANG is our translation of option volatility into potential underlying movement. 

In gambling terms, this is where option bookmakers "set the line."

This expectation of movement (i.e. volatility) changes in real-time as underlying moves, option prices change, supply/demand of options change, etc. Take a peek at our write-up on the dealer feedback loop for more info.

In the world of options, volatility is generally expressed as the "annualized 1 standard deviation of the underlying's probability density function".

For the mathematically challenged (sorry, the differently abled!): when prices change, the new price should fall between the red lines most of the time.

And by most of the time, we mean there's a 68% chance.

Question: How often did the daily price movement of the SPX satisfy the range assumptions implied by the BANG?

Answer: 62% of the time (that's pretty damn good for a 1-year sample)

What does this tell us?

The option markets can accurately price underlying potential movement! Understanding the BANG and how the market gyrates within its range (most of the time) will give you an advantage. Or differently said...

Without understanding how the option market prices potential oscillations, you are at a disadvantage!

The BANG will tell you the SPX range before the day even starts!

But 62 < 68, what does that mean?

Realized volatility is lower than implied volatility. You can look at this as: on average, if you were to buy an option, you probably slightly overpaid. And if you sold an option, you probably collected a bit more than you needed.

That's kinda odd, because wasn't last year a bloodbath?

Absolute price action over the year was definitely "no bueno", but on a daily basis, there were no persistent outsized shocks that the option market didn't price. AKA no one was really caught off guard.

Make Me a Better Trader

Now let's really find out what happened. Which days were good swing/momentum trading days? Which days were mean reverting?

The below tables are quoted in Close of Day Price in Relation to the Center of the Daily Range. Formula = SPX [close] - Average (SPX [low], SPX [high]).

Example: the red star closing price is 20 handles below the center of the day's range, and the green star closing price is 10 handles above the center of the day's range.

Okay, so the market seemed to settle near the center of it's daily range, regardless of what happened with the BANG. A couple handles lower if BANG realized, and a couple handles higher if BANG did not realize.

From that data, 2022 just looks like a slog (on average). Trading a daily mean reversion strategy had an edge, if and only if you did it consistently everyday (let's be honest, you ain't!)

But how do I find momentum days? I want to ride a wave when I see it, and then get out!

Okay, let's add in a second factor...did option volatility also increase/decrease?

So, unrealized BANG is mean reverting...kinda like what we saw above, BUT

When the BANG is realized, you must watch option volatility!

If volatility decreases intraday, the market closes 20 handles higher than center. If volatility increases intraday, the market closes 25 handles lower than center.

This time lets learn from history and start using these relationships to our advantage in real-time. These are not lagging indicators!

As always, pursue the process NOT the profits! See you tomorrow!