Special thanks to Nick Pritzakis of www.questoptions.com on the following guest post. Before you read this, one thing you should know is the following: This analysis will not tell you exactly where to buy and where to sell. Nick's goal is to teach people how to fish, not simply serve up the fish on a platter. Nick goes into extreme detail in futures options to determine what he feels are the best possible ways to play the market. Depending on volatility, some strategies are better than others and this is the real power of his analysis. We hope that you enjoy:

Ok, this first chart looks at the realized volatility in ES futures for the last 20, 40, 60, 80 and 120 trading days. Not only that, but volatility is estimated using two different measurement types. Why? Well, by using two estimators we are able to capture more information about the realized volatility. The first estimator(C) is simply the close to close volatility. Now, the second estimator (YZ) captures the intraday volatility (open-high-low-close).

Why is this important and how can it be used? Quick example, let’s assume that ES futures closed at 1400 yesterday and settled at 1400 today. The first estimator would show that realized volatility was 0%. Now let’s assume that ES opened at 1405, had a high of 1410, a low of 1390 and closed at 1400. Based on the example, intraday volatility is greater than overnight risk. In fact, the overnight risk estimator is doing a poor job of capturing true volatility.

The intraday estimator is giving us information that the close to close estimator (aka overnight risk) is not. If you are an options trader that has to adjust positions, this information is extremely valuable.

Moving On…

The slope of the realized of the volatility curve has a positive skew. Why is this strange? Well, there is a tendency for short term volatility to fluctuate more than longer dated volatilities. Not only that, but less observations equal greater sampling error…also, with more observations the bigger moves will be averaged in. In most cases, we’d expect to see volatility be greatest near term and the shape of the curve to have a negative skew.

As you can see, this is clearly not the case. In fact the last 120 trading days have been more volatile than the last 20.

In addition, the intraday volatility has been greater than the overnight risk over the last 20 trading days. This means that lately it’s made more sense to make adjustments right before the close vs. trying to make them intraday where price action has been wilder.

This all could be argued that this is a sign of complacency.

This next chart looks at the term structure in ES options. When observing implied volatility, the most important options are the at-the-money.

The ATM implied volatility in ES options increased slightly last week, as ES futures prices inched lower. Now, the shape of the curve is positive…this is actually normal. Why? Well, with more time until expiration, you have greater uncertainty; and hence you’d expect to see greater implied volatility as we move further out in time.

Next we want to compare the realized volatility to the ATM implied volatility.

Now, the spread between realized and implied volatility is mixed. For example, if you compare the last 20 trading days to the SEP contract, the spread is flat. However, when you compare the last 40 trading days to the OCT contract, the spread is positive. The spread is also positive when you compare the last 60 trading days to the NOV contract…and the last 80 trading days to the DEC contract.

Ideally, you’d like to go long volatility when the spread between realized and implied volatility is either flat or negative. In addition, you’d like to short volatility when the spread between realized and implied is positive. Keep in mind, the wider the spread the better…you need to overcome transaction costs as well as the bid/ask spread.

In this case, the spread is positive for OCT, NOV and DEC… but it’s pretty narrow and there isn’t much edge in selling volatility at these levels. However, it’s important to put realized volatility into context.

In order to strengthen our comparison between realized and implied volatility, a volatility cone is constructed.

Now, realized volatility is at or below the 25^{th} percent threshold for the last 20, 40, 60 and 120 trading days. However, the last 80 trading days are sitting around the historical median.

Ideally, you’d like to go long volatility when the spread between realized and implied is either flat or negative… and realized volatility is relatively low. In fact, the SEP contract actually fits this description nicely.

Just like we compared realized and implied volatility…we want to compare the realized distribution to the implied distribution. We accomplish this by setting up skew and kurtosis cones and then comparing them to implied volatility skew charts.

The kurtosis cones are used to analyze the flatness or peakedness of a returns distribution…compared to the normal distribution.

Usually, the distribution has higher peaks around the mean when compared to the normal distribution. In addition, there is a higher than normal probability to see extreme price moves (on both sides, up or down)…AKA fat tails.

In other words, the higher the kurtosis is (+)…we should expect OTM and deep ITM options to have a higher implied volatility than the ATM options. If the kurtosis is (-) or 0, we should expect the OTM and deep ITM options to have a similar or lower implied volatility than the ATM options.

Now, moving across the curve we are seeing moderately positive kurtosis. We’re actually at the historical median for the last 30 and 60 observations. However, we’re near the 25^{th} percent threshold for the last 90 and 120 observations.

Under the present conditions, we should expect to see OTM options and deep ITM have a greater implied volatility than the ATM options. Which OTM options, the calls or the puts? We need to look at a skew chart for further insight.

The skewness cones are used to analyze the symmetry of the distribution. According to the sample, the distribution in ES futures prices has a slightly negative skew.

This means that the distribution has a longer tail on the left when compared to the normal distribution. In other words, we should expect to see put options be more expensive than call options.

Currently, we are witnessing a positive skew over the last 30 observations. This would imply that call options should have a greater implied volatility than the equidistant put options.

Now, the last 60, 90 and 120 observations have a negative skew.

This chart compares the normal distribution to the actual distribution over a longer time horizon, one year of daily periodic returns.

These charts look at the entire volatility smile in ES options. The charts compare implied volatility to moneyness. Now, moneyness is simply the strike divided by the futures price (adjusted for time).

We mentioned that the ATM options are the most important to observe…but great insight can be gained by looking at the entire volatility smile and the behavior of the OTM options.

**Strategy Analysis**

On the news front we’ve got some retail names with earnings announcements, US GDP, US Job Claims, US Personal Income, GER CPI, EUR CPI and the Jackson Hole meeting just to name a few events on tap…

Ok, so realized volatility is relatively low for the last 20, 40 and 60 trading days. Not only that, but when you compare the last 20 trading days to the SEP contract, the spread is flat. This is an ideal set up for those who want to go long volatility.

When looking at the other contract months, the spread is slightly (positive but very narrow). There isn’t much edge gained in shorting volatility (the spread becomes narrower if you throw in transaction costs and what you lose from the bid/ask spread). With that said, short volatility strategies should be avoided this week. Long volatility strategies are favorable, specifically in the SEP contract.

For the most part, implied volatility tends to rise when the underlying futures price declines. You can use this information to place volatility trades that have a directional bias if you wish.

**Strategies to Avoid:** Naked Short Puts and Calls. Short Straddles, Short Strangles, Iron Butterfly, Iron Condor, Short Ratio Spreads.

**Favorable Strategies:** Long Straddle, Long Strangle, Zero-Cost Put Ratio Back-Spread, Risk Conversion, Long Wrangle.

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Cheers,

The TradingPub

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Risk Disclaimer: Past performance is not indicative of future results. Futures trading involves substantial financial risk. Views of guest commentators do not represent those of TradingPub.com. Article intended for educational purposes only and not meant in anyway as a solicitation to buy or sell certain securities. Please consult your personal financial adviser before using this information for your own trading purposes.