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Market volatility and fishing bobbers

I am a seasoned pit trader. I have stood back to face for 20 years sharing sweat in different pits around the world. My specialty is options. After all these years I am still amazed at the amount of investors and speculators in my market that don't really have a good handle on what I do for a living. Just ask my wife or my sister. At career day they say that I don't have one.

I am often asked about options and what is the most difficult thing to understand. As I write this article I think back to my beginnings and often wonder if there was a defining moment that could explain why I have pursued this line of work. Firstly, I am still learning the trade. I think if you ask any professional athlete the same question they would give you similar answer. We are like professional athletes. There are many of us that want to be in the pits but only a few can make a lasting career out of the chaos. The chaos will give way to electronics soon but the fundamentals of the trade will be the same.

After two years of training when my brain was at its brightest, I was promptly put into the corn options pit as a young 22 year old ready to make his killing. Within my first week I was the one getting killed. Why? Well, I believed I was very well trained. I had passed two difficult company exams and earned the trust of my employers. They had backed me with their in-house education as well as their capital. All I had to do was put them both together and the world was my oyster. I could not have been more wrong.

It was like a puppy dog hearing himself bark for the first time. Was that really me? Was I responding to the right broker in the correct manner? Was my price right and did he/she execute the trade with me? The red mist had descended and if there was a fire in the building I could not have found my way out.

How did I lose the money? It took me a while but it comes down to one thing. Volatility. What is volatility? I am sure many people have written about it and I am positive I am one of those that read what they all wrote but it didn't help me in my time of strife. You may have heard other traders/brokers speak about volatility but nobody ever really puts it into terms that you and I can understand. I am going to give it a try.

First we should talk about implied versus historical. I wasn't sure what they meant when I first started but I can put them into terms that make them simple now.

  • Historical Volatility: A measure of price fluctuation over time. The time frames are usually 30, 60 or 90 days but can be catered to different preferences and different time frames. What has been the historical volatility of this contract over the last X time frames?
  • Implied Volatility: The volatility of an underlying as prescribed by the prices of the options.

So, what do these mean to you and I?

The first definition doesn't really mean anything to an options trader except for the relevance to the second definition. For example; are options prices being modeled near the historical volatility of the underlying that I am trading or is there a significant difference? If the historical volatility of corn futures is 18% I am going to be careful about getting long options with a volatility of 25%. Those options at 25% are forecasting a future historical volatility of 25% but in reality it has been only trading at 18%. Either the market knows about a significant upcoming event or there is a high likelihood that the options being priced today are reflecting an unnecessarily high future historical volatility.

That's a mouthful.

Let's try this. We (options specialists) use computer models to generate our options models and the tables that we use to make options prices. Some use Black and Scholes. Others use newer more complicated models but in the end we basically come up with the same tables and options prices. These computer models take into consideration, time to expiry, current supply and demand of the options and riskless rates of return. What that really means is that we have a small computer in our hands that will generate the prices that we quote the brokers that go out to the general public.

So when you hear your broker say that volatility is up that means that the prices of all options are higher if the underlying contract was unchanged. The same could be said if volatility was down. Often times we will have brokers constantly quoting the at the money straddle. They then will put this price into their options volatility model and it will spit out an implied volatility. Assuming the underlying is unchanged we could have a scenario where the straddle goes up in price (rise in volatility) or down in price (lower volatility). Below is a chart of the different volatilities at different strikes in coffee options. Notice the different supply and demand scenarios in different strikes pushes up or down the volatility in that strike.

What would make this happen?

I have often said that options are a little market unto themselves. Let's assume that the underlying future is unchanged throughout the day. We have customers that are bullish and come into the market all at once and try to buy 10,000 contracts of calls. As the market makers sell these calls they are hedging in the futures pit. Now, let's assume the first batch of calls bought was for 8 cents. Locals buy futures against theses call sales as their hedge. Now, with futures still offered where the locals last hedged, these investors pay 9 cents for the calls. Market makers sell them and hedge at the same price they hedged the sales at 8 cents. What this illustrates is a lack of supply in the calls which in turn drives up the price of the calls even when the underlying does not change in price.

The same could happen on the sell side when speculators come to sell calls and the drive the price down of the calls just on the over supply and multiple sales. Puts also trade this way giving us our mini market within a market.

Volatility can go up or down when the underlying is either unchanged, up or down itself. It all has to do with the supply and demand of the options themselves. In an extreme example, calls could trade unchanged in a limit up scenario if enough outside investors decided to get out of their long calls all at once. The same could happen with puts in a limit down scenario. I like to think of volatility as the water in my pond back home. The puts and calls are represented by the bobbers on the pond. The pond water level is volatility. When the pond is full (i.e. volatility is higher) all the bobbers rise together and when the pond is low (i.e. volatility is lower) all of my bobbers descend together. That is how it works in the pit.

Volatility can be one of the hardest things for a trader to get a good understanding of let alone the outside customers. You have to be keenly aware of order flow and whether or not options as a whole are being bought or sold en masse that day. This condition can change at any time on a dime. Remember that options are little markets unto themselves and like anything else they are driven by supply and demand. In baseball with runners in scoring position we say ducks on a pond. Now when you refer to options volatility it's bobbers on a pond.

Scott Shellady is a CBOT corn options trader. Shellady serves as CEO of Bradford Capital Management. E-mail him at

I am a seasoned pit trader. I have stood back to face for 20 years sharing sweat in different pits around the world. My specialty is options. After all these years I am still amazed at the amount of investors and speculators in my market that don't really have a good handle on what I do for a living. Just ask my wife or my sister. At career day they say that I don't have one.

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