Wider Spreads or More Contracts? Nick Battista has the answer.

Watch Now

Market Measures

Monday – Friday | 9:00 – 9:20a CT

Time & Volatility

Market Measures

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Time and Volatility play important roles in the trades that we place. The implied volatility environment is crucial to our success. Additionally, the expiration cycle that we place our trades in determines the amount of theta that we will receive.

Today, Tom Sosnoff and Tony Battista look at the relation of time and volatility. Specifically, they see how much theta they are able to receive compared to their vega (volatility) risk. This allows them to see if they are collecting enough decay to compensate for risk of volatility increasing.

The guys look at three different studies to put this relationship into context. First, they compare a typical 45 DTE cycle to a longer dated, 75 DTE cycle. In the longer cycle you will have a larger amount of theta but an increased vega risk. They find that a 45 DTE cycle provides a better ratio.

Next, they look at how a changing volatility environment impacts the theta / vega relationship. They find out that a high IV Rank will provide a larger amount of theta and smaller vega risk so placing short premium trades are better in a high IV Rank environment.

Finally Tom and Tony look at using an initial theta / vega ratio to determine if a trade should be placed. They find out that the win rate and P/L per day are highest when a strangle has an initial theta / vega relationship of 30% or higher!

Tony B: Thomas, we're back my friend! Market Measures! Before we get to that, you asked me where VIX settlement was. VRO is how you get the VIX settlement. Looks like 16, 64.
Tom S: Nice little markup. Not high enough, I need it to go over 18.
Tony B: For a butterfly….
Tom S: We had a long butterfly for kind of... We had a long free...
Tony B: Now your daughter's not talking to you again?
Tom S: No, she didn't lose any money trading.
Tony B: Okay.
Tom S: She was long in for credit.
Tony B: It's a markup from where it closed but it's lower than where it's been the last two.
Tom S: Yeah.
Tony B: Mm-hmm.
Tom S: She was in it for credit. I did the VSX trade.
Tony B: Mm-hmm.
Tom S: Down about eight trades. They were a little slower than yesterday because we don't have the same amount of positions on it.
Tony B: Mm-hmm.
Tom S: We bought back three traunches of S&Ps that we sold yesterday for a nice little profit. I just a Put spread on at Netflix. I bought the 70, 75 Put spread for $2.49. It was $2.48 or $2.49, I'm not sure.
Tony B: $2.48.
Tom S: $2.48.
Tony B: Mm-hmm.
Tom S: I bought that Put spread for $2.48, Just because I'm practicing what we preach with the Robinson. I just went one strike in the money, did the whole thing.
Tony B: So you did a poor man's covered call in there, right? It's basically what you're saying?
Tom S: No. I bought a Put spread...
Tony B: You just put the March 475, 470 Put spread.
Tom S: I did exactly what Robin did. In TLT I didn't exactly what we talked about with Dillon which is selling the 26, 127 strangle, selling premium in a non-correlated high vol underlying. In the index we bought back our short Puts from earnings by last night. In BSX we did the poor man's covered call. The only bad trade we got going on today is Fossil and...
Tony B: It's not adding up to gold daggers.
Tom S: There's nothing we can do in there. We're trying see some March calls and we'll wait. We've made our beds for the next month in there.
Tony B: Mm-hmm.
Tom S: Yuck! Let's see, what else do we got. We're basically doing everything we talked about doing which I think is, really, one of the important takeaways.
Tony B: Bond's starting to rile a little bit, you kind of like that? Maybe the market will sell off Bonds and probably give you a chance to reload?
Tom S: Yeah. I got a very small offer in at 16. Let me just confirm that right now. 16. Yes. I'm a small buyer in the low 70s on the Nasdaq futures and the high 80s on the SMP futures. We'll see what happens there, maybe...
Tony B: Nasdaq futures' about $3.00 off of their lows.
Tom S: Yeah.
Tony B: Nasdaq's been the strongest of the group all day.
Tom S: Yeah.
Tony B: Mm-hmm.
Tom S: Easily, yeah. Which I don't like. I wish the Nasdaq was falling out of bed.
Tony B: Sure.
Tom S: Who's higher? Tesla's higher, Facebook's higher, Twitter's higher, Netflix is higher, Apple's higher. It's a who's who of... Starbucks, Google, GMC are...
Tony B: Pick your poison.
Tom S: These are all the stocks I watch. They're all higher than all the Nasdaq's, but it's okay. Nasdaq, don't worry. Your day'll come.
Tony B: Mm-hmm.
Tom S: You're not immune to what's about to happen to you. We call this segment Time & Volatility. Enjoy. It's really well put together. The relationship between time and volatility plays a critical role in the price of options. Essentially it allows us to determine how much theta we're collecting relative to the amount of vega risk we are taking on. One of the things I want to talk about here, having a conversation now with tens of thousands of people. I don't know how many people are watching right this second, but over the course of the day, close to 50,000 people will view tastytrade. A little over, a little under, whatever it is. Depending on how active or other things going on. Sometimes when people are watching tastytrade, they'll watch Market Measures. Sometimes they'll watch Tim Knight. Sometimes they'll watch bits and pieces. What's amazing is, this is the most popular segment that we do over the course of the day, and this is the most complex topics. This is the most research, the most complex topics. This is the part of the discussion where we try to push it as hard as we can. The whole argument that...
Tony B: Of dumbing it down?
Tom S: Of what Dylan made before, "People just don't have the time for this." It's ridiculous because we've proven this both through TOS and through tastytrade now, that people will actually eat this stuff up if they have an opportunity to get it. What people don't want to do, is they don't want to pay for bad information. And they don't want to pay somebody else for another upsell. They don't want to make somebody else rich, they want an opportunity to make themselves rich.
Tony B: Sure. A fair shake is what they're looking for.
Tom S: They'll do whatever it takes, and I think we've undersold this whole segment of the population. How many people really want somebody else raising your kids?
Tony B: Nobody.
Tom S: I can't be home all day to raise my... My dogs are older now, but I think that's acceptable.
Tony B: Sure.
Tom S: Okay. I don't want anybody touching my money.
Tony B: Mm-hmm (affirmative).
Tom S: I really don't. I don't trust JP Morgan. I don't trust Merrill Lynch.
Tony B: Mm-hmm.
Tom S: Okay. I don't trust anybody else out there. I don't trust the biggest, baddest hedge fund managers in the world. I wouldn't give David Tepper a dime if my life depended on it. Or Paulson, or anybody else. You're crazy! They have no edge over us!

Tom S: Okay. Anyway, let's do Time & Volatility here. I think the challenge is, let's get this information out there and whoever the hell wants it, eat it up. The theta vega relationship can be calculated as a percentage. The higher the percentage, the greatest amount of theta we are obtaining relative to the vega risk. So, how much premium can we get relative to the volatility risk that we're taking. A higher percentage would also provide optimal scenarios for selling premium. Makes sense.
Tony B: Sure.
Tom S: Let's try to figure out these numbers, man. Let's see what works.
Tony B: Dig deep a little bit.
Tom S: We calculate this relationship by simply diving the initial theta by the initial vegas as follows: theta divided by vega times 100. All right? The number of days to expiration has a significant impact on this relationship. The longer dated cycle may provide additional theta collected, but is it sufficient to offer the greater vega risk? To test this we looked at our standard time compared to the next monthly cycle. Again, our goal, always trying to improve. Always trying to improve what we deliver content-wise. Let me take it a step further; the specifics of the content. Study. Spiders, Qs, and GLDs. 2009 to present. 219 occurrences. We compared the theta/vega relationship on a one standard deviation strangle in two time frames. For starters, we'll do short time frames going forward, but this one, we want to do 45 days and 75 days 'cause we want to prove concept here. Can we quantify this 45 day time frame? What we did is we looked at the one standard deviation strangle. 45 days to expiration and 75 days to expiration. The 45 day cycle resulted in a higher percentage overall. In the 75 day cycle we're seeing a lower amount of theta for a higher amount of volatility risk. That doesn't make any sense. We would much prefer the opposite of that. In the 45 day cycle your theta was 4.24, your average was vega was minus 17.4, and then your ratio was 24. Remember, the higher the ratio, the better your risk reward. In the second study, which was 75 days to expiration, the average theta was 3.15, the average vega was 24.1, minus, and then for total number, 14%. In the 75 day cycle, we saw a lower amount of theta: 3.15 to 4.26. For a higher amount of vega risk: -24.1 verse negative ...
Tony B: The higher that negative number is the worse it would be for your point of movement.
Tom S: Exactly.
Tony B: Mm-hmm.
Tom S: The net result came out to 24 verse 14. Again, supporting that 45 day number as opposed to going longer.
Tony B: This something you've ever looked at before?
Tom S: Never.
Tony B: Okay. Nor I.
Tom S: Something I could've...
Tony B: Told you because you know that longer theta options are going to have more vega to them.
Tom S: I'm not even sure I could've guessed how it would look. I would assume the 45 days is optimal just because of all the research we've done, but you've got to keep doing more and more research. The second study was knowing we collect more premium in high implied volatility. We wanted to see the impact IV Rank has on this relationship. To do this we looked at the average theta/vega ratio for the one standard deviation strangles executed in different implied volatility environments. Now we're getting to the point where this stuff is really cool. We're taking the IV environment below 25, between 25 and 50, and greater than 25. We're looking at that, one against the other. We see that the high IV Rank and the 45 days expiration cycle provides the highest percentage of theta relative to vega risk. That's all you care about.

Tom S: How much am I going to collect in high IV relative to what high volatility risk is. In the 45 days to expiration you can see with the high IV over 50, everything just... We keep getting back to that same kind of inflection point.
Tony B: Right.
Tom S: The event point. What it essentially says is, you give me a high IV over 50 like in TLT, or whatever, today. You give me 45 days to expiration or 31 days or whatever the number is closest to 45 days, and I'm going to give you a relatively good chance of making money with a manageable vega risk. Okay, that's really cool.
Tony B: That's my advantage, right?
Tom S: I'm not going to go back because I don't want to keep harping on everything else that we talked about earlier, but the reason it's so important to manage your own money and to learn this stuff is because, I promise you, that whatever money manager you're using is deciding what to buy based on some piece of software that has no idea what any of this even means.
Tony B: That's based on how much they got to get paid for holding it over a period of time.
Tom S: We're not even getting into the conflicts.

Tom S: The conflicts on their own should discourage from ever doing that. The idea of what we're discussing here has never even been approached by anybody managing your money because they don't even have the available to scale to pull this off. It does not exist for multi-billion dollar funds. You have a hundred billion dollars in a fund, you can't do this if you wanted to.
Tony B: That's sad.
Tom S: Forget that they don't even understand, you couldn't even do it if you wanted to. That said, that's the argument for doing yourself. Using the same underlyings, we wanted to see the effectiveness of the using the initial theta/vega relationship as an entry metric. This is study number three. How does this metric affect the win rate and P and L on a one standard deviation strangle using the 45 day cycle? This is really interesting now 'cause we're taking it to a third level. We're going to look at this. We have here now is the theta/vega relationship less than 19%, between 20% and 29%, and greater than 30%. What you saw here is, the more conscious you are of this relationship, the average P and L per trade, and the percent of wins, is dramatic. Placing trades where the amount of theta was at least 30% of the vega risk resulted in the highest win rate and the largest P and L per day. Can you imagine if we pull this off inside of Dough?

Tom S: And get all this stuff done?
Tony B: ….. checkbox to put in before you make the trade [crosstalk 00:12:30]
Tom S: Can you imagine? We talked once about maybe this stuff becomes robotic and this is the new future of robotic finance. Can you imagine once this stuff gets inside the technology, how great your ability is going to be to articulate what you're about to do. It's awesome, man.
Tony B: As that future's making a new low, trading 43, 74.
Tom S: I'm 43, 74 bid and high on one second while you're still on...
Tony B: The MSP's down seven, trading their 20, 88, 50.
Tom S: I'm 20, 88, 50 bid.
Tony B: Dow down 45, trading 17, 956 but three dollars off their lows. Bonds' up 12 but three ticks off of their highs.
Tom S: I have a 16 offer in Bonds. I'm all over the bids.

Tom S: We just bought some Nasdaq futures. We sold these yesterday between 82 and 88. We bought some at 74. That's just one traunch. It's about 20%-25%. We filled this we'd be at 45% from just the scalp from yesterday.
Tony B: Yeah.
Tom S: That's coming in nicely. Adjusting those ratios is actually working pretty nicely. All right, that's it. That was...
Tony B: Looks like that was almost 14 points higher. Good.
Tom S: All over the place though.
Tony B: Mm-hmm.
Tom S: Yeah, that part of the trading's doing quite well. Anyway, I think...
Tony B: Great feed but I'd love to see a screener in Dough that would find the trades that meet...
Tom S: Does it really find the trades that will just eventually...
Tony B: No!.... say yes. This does a vega that meets our range area that you're looking for. That kind of thing.
Tom S: Yeah. I put some Bonds in really small order at 13 just to be back on the board.
Tony B: Man, I remember if you get Bonds buying Bonds that we were short under 45, you were ecstatic. Now you're looking to sell that at 44, 13.
Tom S: Just to throw something up there.
Tony B: Mm-hmm.
Tom S: Just for a scalp.
Tony B: You got one traunch of Nasdaq that you bought at 73, 24.
Tom S: Yeah.
Tony B: Mm-hmm.
Tom S: Great, man. I love this. I could do the theta/vega relationship all day and night because what it does is, it validates the high IV, it puts context around risk reward, and it validates the 45 days to expiration. You got more numerical validation of 45 days, more numerical validation of the high IV, and also a way to put numbers directly around risk and reward; volatility verse theta decay.
Tony B: Let's take a quick break. We'll come back. We've got Good Trade, Bad Trade next. You're listening to tastytrade Live.

Market Measures More installments

See All »

Latest tastytrade Videos As of September 26

Most Shared From the last 30 days