JC Penny [JCP] in the first figure below displays a classic divergence on the daily chart on 02/08/2010. Note the nice inverted 'V' shape formed between the low on 1/28/2010 and th lower low on 02/05/2010. The MACD is clearly diverging to the upside. In the lower time frames in the second figure below, JC Penny 60 minute price bars through 02/08/2010 show MACD and price are turning up.

The 60 minute chart on SPY is showing a divergence with the MACD, the indicator shows prices should be at  @108, however Feb 108 puts this close to expiration need a powerful catalyst from lower timeframe to offset the time decay. Both the 108 and 110 puts are well down in price today.
 


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What is Compression and how does this relate to MACD divergence?

Have you ever COMPRESSED a spring? Push it against the ceiling, what happens when you release it? Push it against the floor, what happens? Same thing, right? Now, if the ceiling were getting lower and you compress the spring, does it move the same distance as when the ceiling was higher? YES, but since the backdrop(ceiling) was already lower the 2nd time the spring actually went much lower than it would have, right? Replace the SPRING with PRICE and the CEILING or FLOOR with the MACD and you have the perfect analogy for MACD divergence.

 

A rule often echoed in volatility trading circles is that an option is only ever worth what someone will pay for it, or conversely what someone will sell it for. Primarily this is due to the fact that price is invariably indictated by supply and demand however there is a broader manifestation that has always been apparent, but that is only now evident after the 2008 global financial crisis and the redundancy it affected upon Efficient Markets Theory.

Certainly, an option trader will most likely need to close out their position at some point, particularly if value is available for the privilege of doing so. The new paradigm that option traders have to work with however, encompasses the fact that regardless of where the rest of the market is pricing volatility, taking a volatility position and maintaining it will (apart from margin requirements) remain quite independent from the rest of the market.  It is not uncommon for implied volatility to be trading at 12% when historical volatility is actually 6%. Indeed, in the 1980’s and early 1990’s, option markets were in their infancy and traded at premiums that were nothing short of arbitrary volatility inputs into a model. When the astute realized the discrepancy between theory and reality, volatility hammers were deployed into service across the globe.

Of course the same can occur when markets are inherently more volatile than implied volatility may suggest. A poignant example of this is the fact that most equity markets travel at a conservative 8%-11% historical volatility with the exception of a handful of trading days throughout the year when volatility will breach all containment lines and register at the 35%-40% mark. It is for these reasons that traders need to bear in mind that they are trading premium, and this is a daily compromise between time decay income or expense, and the re-hedging income or expense. The mathematical model however (invariably the Black-Scholes or a variation of it) will assume constant volatility from until the expiry of the contract.  This is a clear limitation of the model which needs to be understood and catered for in the real world whose only constant is that of change. Of course, the volatility trader is able to reduce the risk of all these external forces by offsetting their position with other options. Due to the fact that they too labor under the same limitations, the risk of unforeseen eventualities hailing from outside the market place will be reduced.

Being a volatility trader is lucrative, but make no mistake, particularly in the post 2008 climate of heightened vigilance and regulation, the cost of funding positions will escalate. This is pertinent to volatility traders for the simple reason that they are required to hold open positions for an extended period of time. The beauty of volatility trading is found in the opportunities it provides. Options are a diverse animal, with inherent features that are complex and yet reliable.

From first principles, trading volatility is opposed to taking a directional view. Volatility is premium, and that is all that is of concern. To capture this premium in order to trade it, one must rely on mathematical models to provide a benchmark with which to be guided. It is worthy to note that this matrix of prices is merely a benchmark to shed light on the theoretical value of options given certain inputs such as strike, underlying price, type, days to expiry and notional volatility. As the fiasco of 2008 clearly indicates, theory is not reality. Real life will often outperform academia.

Apart from relying on the price output of the model, a trader will also be heavily reliant on the delta output, which represents the rate of change of an options price to that of the underlying. As a volatility trader, every option position needs to be hedged in order to capture the time premium of the option, and the delta will provide the trader therefore, with the precise ratio to apply in hedging the option position using the underlying instrument.

As the market moves upward and downward, the option’s price will change, but due to the fact that it has been hedged according to the precise delta output, the position will to some extent be protected; the time value has been captured. The fact of the matter is however, that the delta of an option is not static; it too changes as the market moves. The rate of change of the delta is the gamma, and will mean that when the market moves, the option position at some point will be found to have a different delta, and so the position is either over hedged or under hedged as the case may be. If the resultant tweaking of the hedge results in buying the underlying after a move upward, or selling the underlying after a move downward, this locking in of loss will be attributed purely to the short option position it supports. Even when a position is hedged, the seller of options bears unlimited risk. Of course when a profit is locked in each time the market moves upward and down, the security and benefits of a long option positions is enjoyed.

Again however, it must be noted that trading volatility is a daily trade-off between the competing income streams of time decay and hedging. While option buyers carry the risk of only a limited loss, there is certainly no joy to be found in a portfolio suffering an expensive  time decay bill each day, and the market stagnant with no opportunity to re-hedge.

Risk denotes the probability of an outcome, when an individual places an investment of value in the path of forces outside their control. Straightaway the madness of this practice is revealed, yet the pages of history are littered with those that have brought about the greatest advances mankind has ever made in return for risking something of value.

It may be interesting to note that the volatility of the recent global financial crisis saw the advent of many newcomers onto the BRW Rich List in 2008, and the contention that risk is defined by the market falling is not to the point. Today, due to the very existence of derivatives such as options, swaps and forward rate agreements, an individual can direct risk and return to almost every possible market contingency, regardless of the volatility exhibited.

The Bell Curve represents a distribution of events, with the ‘bell’ representing those events that are most likely; events that are in close proximity to present market price. These resemble at-the-money options. As we get further away from conditions prevailing at the time, the likelihood of particular events occurring will not only decrease, but will decrease in probability at an increasing rate. These less likely events take their place along the tapering edges of the bell, extending to both extremes. A pricing model attributes time value in this very fashion.

The standard deviation is the unit used to measure the probabilities transgressed from the status quo, to the market price when a particular event occurs. These measured intervals decrease in size, as the two poles of this dimension are approached; the difference between a movement of one standard deviation and two standard deviations will be far greater than that of seven deviations and eight standard deviations.
Primarily, this is due to the fact that there is little difference between probabilities that are small with other probabilities of that class, and similarly, little difference between probabilities that are high with members of that class also. They are described at a high level of abstraction that classifies them broadly as ‘high’ or ‘low’ probability.

However, when events of low probability are compared with those that are of high probability, a happening may be for example, said to be effected by a movement across seven standard deviations. In this event it is a rare occurrence indeed. When volatility is high, it is useful to note that not only are the entire bell and its tapered edges lifted higher on the plane, but the edges of the bell, move closer in gradient to the body. In higher volatility, this is directly due to the indiscriminate application of an increased probability in all possible events. The opposite will be found in low volatility with in this case, the actual bell of the curve becoming much smaller.

Accordingly, a matrix of probabilities is able to be placed in perspective. Heavily reliant on reason, the contention that price and quality are inexorably attached is well founded in history. Even more so in perfect markets, at very least we can state with confidence that low risk and high risk are not uniformly priced.  While the perception of value is a personal value judgment, what is most definite is that markets provide returns that are commensurate with the risk undertaken.

Consideration of the capital needed to fund a position, and also a variety of possible market outcomes must firmly occupy the consciousness of every trader. Insight into one’s own ability to function under the weight of risk is also crucial to profitability, as decision making needs to be carried out as free of subjective influences as possible. At any length, a good rule of thumb will be to allow 25% of risk capital to remain free for unexpected contingencies.

Often it is the case that many traders are adept at handling a winning position, if for no other reason than a person’s demeanor is content and productive. The opposite scenario however will find vastly different outcomes; most people do not react well to adversity and managing a losing position will be as challenging a task as any.

The first hurdle to cross is the subjective emotion that will only serve to cloud judgment. It is at this point that a person will either succeed in handling the contingency, or allow the loss to increase through a lack luster and emotional performance. If emotion is contained, it will be easy for the trader to understand that the most important issue is not actually to avoid losing money; the objective that governs every trading day is to continue an existence as a trader. If one cannot trade, there is no use in discussion of the matter. If one is merely a trader that has had a run of loss, these things can be addressed and most likely reversed.

Survival is the key to ultimate success. With this illuminating realization in place, a losing position becomes merely a thankless task to complete. Certainly, a loss needs to be taken all at once, but when trading options it is important to remain insightful into the features of option trading that could be enlisted to the trader’s advantage. A case in point; if volatility is under enormous pressure and a trader is tempted to accede to the institutional selling that has overwhelmed his already long position, regard may be had to the possibility of continuing to trade the position, but merely to sell more than is bought. For example, rather than refusing even better value if volatility moves lower still, reduce the amount that is usually accepted at the bid, and increase that which is accepted on the offer. In that manner, any value will be diverted with prejudice to any selling that the trader engages in. Due to the increase in selling volume, this will have the net effect of reducing the position, but in a manner that still achieves theoretical value.

This type of strategy will largely depend on the width of the spread that endures within a particular option market, but it is also true that when large moves are occurring whether in underlying instruments or even in option markets through volatility movements, that value is all the more rampant as the market struggles to bring anomalies into line with the benchmark. It is at these very points in time that a trader will benefit from concerted planning for such a contingency. While experience cannot be gained overnight, the realization that all is not lost, that alternatives exist, that the ability to survive is key, and that fear is an illusion will assist any trader in their time of need.

Many people envy the bookmaker at the race track, but rarely does anyone give them a thought when the favorites keep winning. So it is with the market makers who seemingly never cease to quote a price.

 

Market making involves considerable funding abilities. Not only will a clearer demand that margins be funded, but option traders are unfortunately still plagued with many administrative decisions going against the grain of common sense. It is not uncommon for up to 25% of the available funds to be required to remain idle and free of margin commitment. Even if the position in total has very small risk, the number of open positions alone will be margined individually with only a ceremonial discount will be extended in lieu of offsets.

 

The role of a market maker is to provide all and sundry with the opportunity to participate in the market. For this privilege participants will pay a price, and that will invariably be in favor of the price maker. As in most asset allocation, the expense of crossing a spread to enter and exit a position is often the one silent expense that balances against other advantages such as low fees, leverage, and even liquidity. The market maker is not concerned as to what option they are trading, it is the price that an option trades at that is focused upon. Needless to say, every position is hedged immediately, as primarily the market maker is a volatility trader, but one who offsets one position with another, building a portfolio of option positions that is founded on theoretical value.

 

If a benchmark is provided by the pricing model, and allowances for the nuances of supply and demand are incorporated, a market maker can price any option using a combination of these sometimes competing interests, and take advantage of value. In an uncertain world, theoretical value that is mollified by the rigor of the real world is as close to precise valuation that a human being can get. When a market maker’s price is accepted, if care has been taken in pricing, value is undeniably present.

 

Of course, part of the market makers task involves adjusting their prices according to the forces of demand and supply at the time; it makes little sense to offer what is a certain buyer, a price that is unreflective of this pertinent knowledge. Accordingly, the benchmark volatility may need to be revised upward if there is pressure from buyers at the time, and conversely if sellers are predominant. In the fullness of time, the market maker will be accepted on the other leg of their price, and so again capture value. It is not the precise values that are of import but the process of quoting prices. If value is achieved in every trade, profit will accrue, and it is upon this principle that the livelihood of the market maker is hinged.

In order to perpetuate success, DOFPIC provides an environment within which each person can tailor a trading system to address their unique personal characteristics. Developed by the later Dr. J.D. Smith, it will not issue institutional advice that will accrue to a small fortune. It will not offer a trading platform upon which to transact business. It is a way of life to a trader; a garment that imbues a trader with internal legitimacy.

Trading processes must have a clear mandate to achieve specific objectives. The manner on which these objectives are reached needs to suffer revision on a regular basis to ensure optimal efficiency in a dynamic marketplace. A macro view of the trading process needs to be intimately familiar. The more transitions within a trading process, the more discretion is exercised and therefore, the more opportunity for contamination from external sources. The flow of market information into the process is imperative; a trader is not an island however, it needs to be processed into decisions and then to action. Any action needs to be calculated and unequivocal, with absolute autonomy being retained over the result of all trading. When alterations need to be made, they are to be affected without any interference.

With 80% of all trading orders estimated to be stop loss orders, the market is clearly bereft with emotional imbalances. If a sound trading process is executed with Discipline, an advantage will naturally accrue.

Every commercial enterprise has its own housekeeping agenda, and traders need to be Organized. Trading reports need to be recorded and verified, account balances need to be evaluated, and risk management needs to be exercised in a structured fashion.

Undivided attention transports a trader from a generalist to a specialist; a trader needs to Focus.

Closely related to discipline, Patience must be exercised vigilantly so that strict criteria are met before action is taken.

Advice from other market participants is cheap. Independence of thought is more important than market participation itself.

Due to the presence of the framework, Confidence can be derived to deflect indecision and uncertainty.

The above elements of the framework cannot be defined absolutely, as they depend on the shape of the framework itself for their character.                                                        

The DOFPIC framework will house the most demanding of trading systems. While establishing a core from which a trader can gain their identity, it offers nourishment when suffering the slings and arrows of outrageous fortune, and a steadying rod for when sails are billowing out of control in the wind. Within its folds is a holistic view, and it is in such a secure environment that the talented become great.

Often it is the case that many traders are adept at handling a winning position, if for no other reason than a person’s demeanor is content and productive. The opposite scenario however will find vastly different outcomes; most people do not react well to adversity and managing a losing position will be as challenging a task as any.

The first hurdle to cross is the subjective emotion that will only serve to cloud judgment. It is at this point that a person will either succeed in handling the contingency, or allow the loss to increase through a lack luster and emotional performance. If emotion is contained, it will be easy for the trader to understand that the most important issue is not actually to avoid losing money; the objective that governs every trading day is to continue an existence as a trader. If one cannot trade, there is no use in discussion of the matter. If one is merely a trader that has had a run of loss, these things can be addressed and most likely reversed.

Survival is the key to ultimate success.

With this illuminating realization in place, a losing position becomes merely a thankless task to complete. Certainly, a loss needs to be taken all at once, but when trading options it is important to remain insightful into the features of option trading that could be enlisted to the trader’s advantage. A case in point; if volatility is under enormous pressure and a trader is tempted to accede to the institutional selling that has overwhelmed his already long position, regard may be had to the possibility of continuing to trade the position, but merely to sell more than is bought. For example, rather than refusing even better value if volatility moves lower still, reduce the amount that is usually accepted at the bid, and increase that which is accepted on the offer. In that manner, any value will be diverted with prejudice to any selling that the trader engages in. Due to the increase in selling volume, this will have the net effect of reducing the position, but in a manner that still achieves theoretical value.

This type of strategy will largely depend on the width of the spread that endures within a particular option market, but it is also true that when large moves are occurring whether in underlying instruments or even in option markets through volatility movements, that value is all the more rampant as the market struggles to bring anomalies into line with the benchmark. It is at these very points in time that a trader will benefit from concerted planning for such a contingency. While experience cannot be gained overnight, the realization that all is not lost, that alternatives exist, that the ability to survive is key, and that fear is an illusion will assist any trader in their time of need.