Rappert's straddle forecasting charts

[RapperT 336]

i cant tell if you're trolling me at this point or not..lol

Here's a simple way to think about it.  theta is the cost we pay for exposure to gamma.  if we dont pay for gamma (or pay way less than normal), that's an edge, like it or not.

 

These charts highlight that relationship.  If you're getting hung up on the divergence of the two lines, you can just look at the value of the blue line to identify straddles that are likely to hold their value well against theta into earnings.

 

We will add an explanation of a sample chart to my thread on the general board.

Edited September 18, 2017 by RapperT

[RapperT 336]

 

 

Explanation of Earnings Charts:

 

Definitions:

 

Normal IV: Implied vol prior to any influence from the upcoming earnings. Can be thought of as “fair” volatility.

 

Earnings IV: The implied volatility rise due to the upcoming earnings cycle.

 

Theoretical Delta Neutral Straddle: An artificial straddle that is perfectly delta neutral. This allows us to isolate price changes in the underlying options due solely to IV rise.

 

Normalized IV Curve: We look at historical implied volatilities and adjust them to take into account the current normal IV and then forecast an IV return curve over the next several days. This allows us to use historical IV from different periods without any bias due to higher or lower overall IV in the market. This curve shows how the IV changes over the course of the trade.

 

Normalized straddle prices: This is the blue line on the chart. It shows how the value of a theoretical delta neutral straddle will change over time based solely on the IV curve. The inputs to this chart are normal iv, earnings iv, normalized IV curve, the black scholes model and days to expiration etc.

 

Standard straddle prices: The orange curve on the chart. This shows how the same straddle would perform if there were no IV price spike.

 

Advantage: The difference in accumulated theta decay between the normalized straddle prices and standard straddle prices. This should be evident if you understand the relationship between theta and gamma. (Note: advantage can be used to calculate edge and fractional position sizing). Simple way to think about it...the difference in the two line shows you the amount of gamma you’re getting for free.

 

(Note: I get it is a little confusing to look at the return stream instead of actual option prices. We did this for a number of reasons related to future plans with a more automated trade system. If you want to convert it to an actual straddle price simply take the price of a delta neutral straddle on day t-25 and multiply it by the daily values of the blue line in the chart. This will give you an actual price forecast for that straddle. )

 

How to use the chart: 4 scenarios.

 

Scenario 1: No significant advantage. Downward sloping blue line.

 

 

 ‘

 

 

 

This shows Costco. Notice the blue line not only slopes downward it never opens a large gap from the theoretical price. While there is a slight advantage the model does have some error in it. This is probably not a good trade.

 

Scenario 2: Advantage but downward sloping blue line.

 

 

 

Notice the time period from around Sep 3^rd to Sep 8^th. The blue line is sloping down showing that without any movement in the underlying the straddle will lose money. However, it still has a wide gap between the blue line and orange line. That means that if you got in around Sep 2^nd you probably got a lot of gamma for free. This trade (Sep 2 to Sep 8) should have a positive expectancy although a lower win rate than some other trades.

 

Scenario 3: Advantage and a flat blue line.

 

Look at Oracle between Sep 5^th and Sep 7^th. The line for those few days is flat. This implies that if you opened a straddle then you would pay zero theta for 2 to three days of gamma. This is a low risk trade with almost free gamma upside.

 

Scenario 4: Advantage and upward sloping blue line.

 

This is the best scenario. Look at Oracle between Sep 8^th and Sep 11^th. The blue line is upward sloping. This means that you could buy a straddle and actually get paid theta to gain on gamma. This is a great spot to be in.

 

 

 

@RapperT Just so I understand, what about this chart looks good to you, that you don't see in COST?

Edited September 19, 2017 by RapperT

[akito 184]

I don't know about everyone else, but the charts make a lot of sense to me and look like a great resource. Hopefully, more examples and test runs will validate exactly how useful they are. Please continue posting these! Your work is very much appreciated.

Edited September 19, 2017 by akito

[jbthree 6]

1 hour ago, akito said:

I don't know about everyone else, but the charts make a lot of sense to me and look like a great resource. Hopefully, more examples and test runs will validate exactly how useful they are. Please continue posting these! Your work is very much appreciated.

I agree completely. I also love the discussion, and look forward to seeing how we can all help improve the "edge."

[RapperT 336]

23 minutes ago, jbthree said:

I agree completely. I also love the discussion, and look forward to seeing how we can all help improve the "edge."

the bulk of the work is done.  We will look at the model we are using and are likely l to add error bars/price cones.  The next step is to automate and add a functional UI.  But the actual charts wont change too much.

[SBatch 3,123]

@RapperT There seems to be an issue with the SO stream and search functions currently which disallows me from accessing the ACN thread.  Would you please post your ACN chart here?  Thanks.

[RapperT 336]

[RapperT 336]

disregard IV curve text..didnt mean to copy and paste that.  Its our next chart we will be rolling out soon

Edited September 19, 2017 by RapperT

[Stanislav 302]

Quote

Normalized straddle prices: This is the blue line on the chart. It shows how the value of a theoretical delta neutral straddle will change over time based solely on the IV curve. The inputs to this chart are normal iv, earnings iv, normalized IV curve, the black scholes model and days to expiration etc.

@RapperT, can you, please, explain in more detail how Normalized straddle prices (blue line) is calculated? Previously my understanding was that this is just an average IV from past cycles normalized by Normal IV (i.e. divided by Normal IV). But here you mention Black Scholes model is also used to calculate the blue line. So I feel I do not get what the blue line really is.

Edited September 19, 2017 by Stanislav

[RapperT 336]

no its' not just a normalized average IV..this could explain some of our misunderstanding yesterday.

 

its a return forecast using Black Scholes and historical pre-earnings IV.  The look back period will vary depending on the stock (for now) but its a minimum of 4 cycles

Edited September 19, 2017 by RapperT

[SBatch 3,123]

26 minutes ago, RapperT said:

Thanks.

[Stanislav 302]

12 minutes ago, RapperT said:

now its' not just a normalized average IV..this could explain some of our misunderstanding yesterday.

Yes, exactly.

 

12 minutes ago, RapperT said:

its a return forecast using Black Scholes and historical pre-earnings IV.  The look back period will vary depending on the stock (for now) but its a minimum of 4 cycles

Sorry, no trolling. But I still do not understand. Can you, please, provide some example for the calculation?

 

So, we have historical pre-earnings IV, let's say IV1, IV2, IV3, IV4 from the past cycles. And we have a NormalIV from current cycle. And we know T - days till expiration as a fraction of the year.

 

Then, what do you do with this data to receive a point on a chart representing a blue line? And how and what for Black Scholes formula is used here? I think a calculation example with some simple numbers can help here to clarify the things.

Edited September 19, 2017 by Stanislav

[RapperT 336]

I think I'm going to stick with the explanation we provided for now.  If i have time this week we can get into BS and forecasting but there is a ton of helpful info online about this subject already. 

Again when thinking of the Y axis,  keep in mind that we are forecasting return of an ATM straddle approaching earnings.  The chart could look different depending what day we begin but the slope on a day to day basis will be the same regardless of when we start.

[Stanislav 302]

Ok.

 

I just want to point out that your explanation is not explaining anything. I know BS formula, know what it calculates and how people use and apply it. Know BS assumptions and it's limitations and so on. I wrote a numerous scripts for option calculations, reverse engineered Brian Johnson earnings volatility model e.t.c. Also I am professional developer. So I feel am I pretty competent. If I do not understand something on the topic, this means the explanations are very imprecise.. to say the least.

 

If you do not want or not ready currently to explain you methodology - that is ok. But, please, do not point "go google it and read". As far as I can tell, my misunderstanding is due to lack of proper documentation, not due to lack of my own knowledge.

 

If some other forum member tells he or she understands your explanation, and is able to provide some simple example how blue line is calculated. Then ok, I'll recognize I am wrong. But I assume you won't find such person.

Edited September 19, 2017 by Stanislav

[RapperT 336]

34 minutes ago, Stanislav said:

Ok.

 

I just want to point out that your explanation is not explaining anything. I know BS formula, know what it calculates and how people use and apply it. Know BS assumptions and it's limitations and so on. I wrote a numerous scripts for option calculations, reverse engineered Brian Johnson earnings volatility model e.t.c. Also I am professional developer. So I feel am I pretty competent. If I do not understand something on the topic, this means the explanations are very imprecise.. to say the least.

 

If you do not want or not ready currently to explain you methodology - that is ok. But, please, do not point "go google it and read". As far as I can tell, my misunderstanding is due to lack of proper documentation, not due to lack of my own knowledge.

 

If some other forum member tells he or she understands your explanation, and is able to provide some simple example how blue line is calculated. Then ok, I'll recognize I am wrong. But I assume you won't find such person.

I'm not sure what your problem is.  If you dont like the charts, dont use them.  I'm not questioning your competency.

  I spent all day trying to work with you and at the end of the day yesterday you still werent aware that our our blue line was a price forecast.  I've gone above and beyond answering your questions on a resource im providing to the board.

I just have another job and I dont have time this instant to answer all your questions.  If you're  familiar with BS than you should understand how we can use historical IV to forecast return.

Edited September 19, 2017 by RapperT

[RapperT 336]

I should mention, the reason I keep posting the charts is because i've had numerous requests to do so.

[Stanislav 302]

3 minutes ago, RapperT said:

I'm not sure what your problem is.  If you dont like the charts, dont use them.  I'm not questioning your competency.

  I spent all day trying to work with you and at the end of the day yesterday you still werent aware that our our blue line was a price forecast.  I've gone above and beyond answering your questionings on a resource im providing to the board.

I just have another job and I dont have time this instant to answer all your questions.  If you're  familiar with BS than you should understand how we can use historical IV to forecast return.

@RapperT, sorry my exaggerated last post. I just did not like your remark "but there is a ton of helpful info online about this subject already". As if I could go somewhere on the web and read something that could explain you methodology.

 

I have no problems with your charts. I see many other member find them to be valuable.

 

I just, having a technical mind, want clear and precise understanding what the charts are and how they are calculated. And for me it is not enough just to write something like "blue line is a return forecast using Black Scholes" and expect this will explain anything. Without even providing a link to the academic publication or an article. It is even unclear what exactly do you mean by "price forecast" or "a return forecast" in relation to Black and Scholes, as, as you definitely know, BS model does not forecast anything. So when I see something like that, I come up with a question. A lot of them.

 

I agree, yesterday was unnecessary busy with messages between us. And, since it seems there is a lot of misunderstanding between us, it may be a good idea to postpone our discussion till the better times. Sorry if my questions trouble you.

[RapperT 336]

no trouble. 

We aren't communicating well on the forecast piece and im not sure how to overcome that.  Im just not willing  write out every equation at this time.

Edited September 19, 2017 by RapperT

[RapperT 336]

For anyone witnessing this exchange:   The explanations in this thread are more than enough to understand what the chart is showing and how it can potentially help us.

We have over 1000 lines of code that is still rough.  Forecasting IV and then using BS to get a price is not an original idea (although we would love to take credit).

If we can identify stocks in which we pay almost nothing for exposure to gamma approaching earnings, there is a clear edge.  We believe we are quantifying that edge effectively enough to help signal when we want to place a trade and when we dont.

 

Thanks

[ccjunk 0]

I like these plots.

 

The model "orange" line shape looks an awful lot like the linear BS ATM straddle price for small DTE, i.e., proportional to sqrt(DTE)

 

Also, in that small DTE BS ATM model approximation, straddle RV is proportional to IV*sqrt(DTE)

 

I don't suppose you have looked at how closely your model line is to sqrt(DTE)?

 

So my interpretation is that the blue line separation shows resistance to the sqrt(DTE) time decay, for certain time periods before earnings, correct?

 

What would happen if you tried normalizing the blue historical lines with 1/sqrt(DTE)?

Edited October 6, 2017 by ccjunk
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[RapperT 336]

12 hours ago, ccjunk said:

I like these plots.

 

The model "orange" line shape looks an awful lot like the linear BS ATM straddle price for small DTE, i.e., proportional to sqrt(DTE)

 

Also, in that small DTE BS ATM model approximation, straddle RV is proportional to IV*sqrt(DTE)

 

I don't suppose you have looked at how closely your model line is to sqrt(DTE)?

 

So my interpretation is that the blue line separation shows resistance to the sqrt(DTE) time decay, for certain time periods before earnings, correct?

 

What would happen if you tried normalizing the blue historical lines with 1/sqrt(DTE)?

thanks for the kind words, im going to shoot you a PM

[candreouTrade 59]

On 9/18/2017 at 5:25 PM, Stanislav said:

Well, if you calculate the orange line as I described above, the calculation is flawed. Since we have an earnings event that occurs before the expiration, to proper model the option price we need to take into account that IV consist of two components: normal option volatility and earnings option volatility. If we just take IV at some point and fix it, and put this into the B/S formula, we are going to receive completely incorrect theta decay, i.e. B/S will tell us that option price will decay as quickly as if we had no earnings event. But we do have a binary event before the earnings.

 

More details on Earnings Volatility calculation can be found in  Brian Johnson's book "Exploiting Earnings Volatility: An Innovative New Approach to Evaluating, Optimizing, and Trading Option Strategies to Profit from Earnings Announcements".

 

I understand what you are trying to achieve - assess a theta decay in option price before the earnings, but as well as @Kim I do not see how you calculation is relevant here. Proper earnings volatility modelling is quite complicated thing - one needs to analyze whole option chain and calibrate a model to be able to split IV to Normal IV and Earnings IV. And so on (some time ago I put a lot of efforts into studying Brian Johnson's work, and can tell it is not as simple as take B/S formula and put some values into it).

I was wondering what you thought of the book?  I've seen it on the OptionSlam.com website a few times, but from the reviews it seemed to over complicate the strategy.

Do you feel there is any good nuggets of information in the book, to help us with our earnings strategies?

[Stanislav 302]

6 hours ago, candreouTrade said:

I was wondering what you thought of the book?  I've seen it on the OptionSlam.com website a few times, but from the reviews it seemed to over complicate the strategy.

Do you feel there is any good nuggets of information in the book, to help us with our earnings strategies?

Brian's book is very good at explaining how to model earnings volatility. But there are no easy recipes there - one needs to put a lot of effort into developing a volatility model, calibrating it, finding proper ways to use it e.t.c. Excel spreadsheets that accompany the book can be of some help for SO straddles strategy, but they require a lot of user input. So, at least for now I am too lazy to try to use and apply them to calc pre-earnings straddles+strangles. My attention is focused at other things.

Overall, I think it may be a good investment of time to read and study Brian's book, especially if you plan to develop your own option calculators/scripts/software that helps to automate the decision process.

[RapperT 336]

not the best straddle trading environment:

 

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