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Is Your Strategy Affected by Shifting Volatility?
Markets never stay the same for long. Your trading may be going very well for a time, and then all of a sudden more losing trades start popping up. You haven’t changed anything, so why will your strategy all of a sudden stop working? While it isn’t always the case, a lot of times it has to do with volatility.
Changes in volatility can have a big impact on your strategy results. If you created your strategy during a “quiet” time in the market, and it worked well, an increase in volatility could hurt you. Similarly, if you created your strategy during a volatile time, and it worked well, a decrease in volatility could hurt you.
I noticed this recently while day trading forex. Volatility has been dropping steadily in the EURUSD since late 2020 (and many other forex pairs). My day trading strategies which attempt to capture strong momentum haven’t been fairing as well, because the “pops” in price just aren’t as strong as they used to be…on average.
Figure 1. EURUSD Long-Term Volatility
Figure 1 shows average daily volatility in pips since 2020, through to April 2020. In late 2020 the average daily movement was more than 150 pips. That means if you picked a decent entry the price was likely to run a fair distance, which leaves a lot of margin for error. For binary options you can choose an expiry that is 5 minutes away or 10 minutes away and it probability isn’t going to affect performance too much since the price is moving strongly.
Progress to 2020 and the average daily movement is about 60 to 75 pips. Typically these moves are choppier and don’t run as far. And when price isn’t running, and instead moving in a move choppy fashion, that means the difference between choosing a 5 or 10 minute expiry can be the difference between profit and loss.
There is a solution. If your strategy is designed for more volatility, you may need to increase the time frame you trade on.
For me, I like day trading on a 1-minute or 5-minute chart, but recently have found much greater success trading on a 1-hour or daily chart. My trades typically last a day to three days (as opposed to 10 or 15 minutes). Notice how three days of trading at the current volatility, equals 1 day of volatility back in 2020. Therefore, by taking trades that last a day or more, I am able to capture similar amounts of volatility as seen on a daily basis in 2020.
If we start to see an increase in volatility again, I will move more focus back to trading on shorter time frames (I still do trade on shorter timeframes, just not as much).
Traders who find success in quiet markets, like now (April, 2020), may have less success in a volatile market. They too may need to adjust their time frame in order to compensate.
The ultimate the goal is to notice when your performance is being affected by volatility, and make an adjustment for it.
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It should be noted that we are looking at averages here. Just because the daily average volatility is dropping doesn’t mean we don’t see big volatility days–we do see them, on occasion.
As traders we need to be on the ball and notice how the day is shaping up. Is it going to be volatile? Are we seeing strong movements? Or is it quiet and we are seeing small movements? These types of questions will determine what type of time frame we trade on.
If you aren’t seeing relevant trends (which make trading easier) on the shorter time frame, switch to a longer one. Regardless of whether volatility increases or decreases, keep your strategies functioning by monitoring volatility and adjusting your timeframe to compensate for these volatility fluctuations.
How To Profit From Volatility
Derivative contracts can be used to build strategies to profit from volatility. Straddle and strangle options positions, volatility index options, and futures can be used to make a profit from volatility.
In a straddle strategy, a trader purchases a call option and a put option on the same underlying with the same strike price and with the same maturity. The strategy enables the trader to profit from the underlying price change direction, thus the trader expects volatility to increase.
For example, suppose a trader buys a call and a put option on a stock with a strike price of $40 and time to maturity of three months. Suppose that the current stock price of the underlying is also $40. Thus both options are trading at-the-money. Imagine that annual risk free rate is 2% and annual standard deviation of the underlying price change is 20%. Based on the Black-Scholes model we can estimate that the call price is $1.69 and the put price is $1.49. (Put-call parity also predicts that the cost of the call and put price are approximately $0.2). The cost of the strategy comprises the sum of the call and put prices – $3.18. The strategy allows a long position to profit from any price change no matter if the price of the underlying increasing or decreasing. Here is how the strategy makes money from volatility under both price increase and decrease scenarios:
Scenario 1: The underlying price at maturity is higher than $40. In this case, the put option expires worthless and the trader exercises the call option to realize the value.
Scenario 2: The underlying price at maturity is lower than $40. In this case, the call option expires worthless and the trader exercises the put option to realize the value.
In order to profit from the strategy, the trader needs volatility to be high enough to cover the cost of the strategy, which is the sum of the premiums paid for the call and put options. The trader needs to have volatility to achieve the price either more than $43.18 or less than $36.82. Suppose that the price increases to $45. In this case, the put option exercise worthless and the call pays off: 45-40=5. Subtracting the cost of the position, we get a net profit of 1.82.
A long straddle position is costly due to the use of two at-the-money options. The cost of the position can be decreased by constructing option positions similar to a straddle but this time using out-of-the-money options. This position is called a “strangle” and includes an out-of-the-money call and an out-of-the-money put. Since the options are out of the money, this strategy will cost less than the straddle illustrated previously.
To continue with the previous example, imagine that a second trader buys a call option with a strike price of $42 and a put option with a strike price of $38. Everything else the same, the price of the call option will be $0.82 and the price of the put option will be $0.75. Thus, the cost of the position is only $1.57, approximately 49% less than that of the straddle position.
Even though this strategy does not require large investment compared to the straddle, it does require higher volatility to make money. You can see this with the length of the black arrow in the graph below. In order to make a profit from this strategy, volatility needs to be high enough to make the price either above $43.57 or below $36.43.
Using Volatility Index (VIX) Options and Futures
Volatility index futures and options are direct tools to trade volatility. VIX is the implied volatility estimated based on S&P500 option prices. VIX options and futures allow traders to profit from the change in volatility regardless of the underlying price direction. These derivatives are traded on the Chicago Board Options Exchange (CBOE). If the trader expects an increase in volatility, they can buy a VIX call option, and if they expect a decrease in volatility, thet may choose to buy a VIX put option.
Futures strategies on VIX will be similar to those on any other underlying. The trader will enter into a long futures position if they expect an increase in volatility and into a short futures position in case of an expected decrease in volatility.
The Bottom Line
The straddle position involves at-the-money call and put options, and the strangle position involves out-of-the-money call and put options. These can be constructed to benefit from increasing volatility. Volatility Index options and futures traded on the CBOE allow the traders to bet directly on the implied volatility, enabling traders to benefit from the change in volatility no matter the direction.
How Implied Volatility Shifts Affect Butterflies
1. How to benefit from the butterfly price table? – I use it to help my entry and exit. After you have done this enough time, you will roughly know what butterfly should cost for similar implied volatility (IV) and days to expiration (DTE). This info will help to avoid or to take advantage of temporary butterfly mispricing.
2. How does IV skew affect butterflies? IV skew affects both prices and greeks but the delta is specifically important in trading M3. Firstly we must understand two aspects of the IV skew – (a) the slope and (a) the shape. Look at the IV curve – the left is roughly linear and then about 40 to 50 pts above at the money (ATM), it starts to curve upwards.
The slope of the linear part typically is steeper when : (a) IV is lower, (b) DTE is smaller.
The lowest point on the curve gets closer to ATM as DTE becomes smaller.
As the market moves up, IV skew becomes steeper, strikes above the market will suffer a bigger IV crush than strikes below the market. Therefore, knowing where the right leg of the butterfly is on the IV curve is important.
Typically after a market sell-off, IV skew will be relatively flatter. For instance, after a sell-off, if RUT is about 10 to 20 pts below short strike of the butterfly, then the right leg will likely be at the point where IV crush will be very severe when the market rebound. In this case, the T+0 line will be inaccurate. It’ll give us a false sense of safety on the upside. That means even if you see a flat T+0 line to the upside, it’s fake. Once the IV crush on the right leg, the T+0 line will sink all of a sudden. That’s because when IV crush, delta becomes much more negative and the P&L suffers more than expected. To mitigate this effect, we need to hedge the upside much more aggressively or pull back the right leg closer, ie turning a regular butterfly to a BWB, or alternatively hedge with more positive that what the software shows.
So we must not think that the lowering of IV is always good for butterfly. That is only true if the IVs of all the legs go down simultaneously. In the real world, that will never happen. As a result, we must not take at face value any of the greeks we see on an analyzer. Instead, we must be aware of where the legs of the butterfly are on the IV curve, understand how individual leg IV will behave and then mentally compensate the greeks.
3. Why is the analysis software inaccurate? The main reason is they don’t model the changes in IV accurately. There are three dynamics that need to be taken into consideration : (1) horizontal shift, (2) vertical shift and (3) slope shift. Let me use an example to illustrate. When the market moves up, firstly the entire IV curve is shifted horizontally. Example – if current RUT Is 1000, ATM IV is 20%. RUT moves to 1020. The IV curve will first shift horizontally such that IV @ 1020 is 20%. After this shift the original strike of 1000 actually shows an increase in IV ! See below L1 to L2.
Then step two – vertical shift down. We know that IV goes down as market moves up. The example below – from L2 to L3. So this effect lowers the IV for every strike, countering the increase in IV in step 1. Depends on which effect is bigger, individual IV might end up lower or higher.
Then step 3 – shift in IV skew. In the case of a reduction of over IV, the IV curve steepens. The example below from L3 to L4. After this clockwise shift in IV curve, some of the lower strike IVs might end up higher than original (ie L4 vs L1).
To accurately model option pricing, software needs to model all 3 shifts. Some analytical software takes into consideration step 1 and step 2 via their CEV. But none currently take into consideration step 3, ie the steepening or flattening of IV skew.
To forecast future IV accurately is not a trivial task. The horizontal, vertical and slope shifts are different for each underlying and these shifts also depend on other factors such as absolute IV level, DTE, and market outlook. To model this accurately, the software must start with an accurate regression analysis of the past data – at a minimum incorporating underlying, DTE and IV level. Therefore, my opinion is that the CEV setting must never be a manually inputted number.
4. Why did OV’s modeling create a problem few months ago? It started with OV trying to do a better curve fit. The old projected IV model was based on linear regression. It did not take into consideration of the non-linear part of the IV skew (ie the curving up part). The new model tried to achieve a better curve fit by incorporating the non-linear part. The irony is OV actually succeeded in a closer curve fit, but because OV doesn’t take into consideration of the IV slope change, the net result is the upper strikes IV became way over projected and the overall IV curve became too flat. That created all the problems in T+0 and deltas that we all experienced. Now, they reverted back to a “worse” curve fit but nevertheless a more accurate T+n lines.
What analytical software packages need are an accurate modeling of the shift in IV slope. If that can be achieved, then the better regression model will work. But I know this is really difficult. I hope they succeed so we can all benefit.
3 Option Strategies To Profit In A High Volatility Market [Guestpost]
3 Option Strategies To Profit In A High Volatility Market [Guestpost]
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Volatility is the heart and soul of option trading. With the proper understanding of volatility and how it affects your options you can profit in any market condition. The markets and individual stocks are always adjusting from periods of low volatility to high volatility, so we need to understand how to time our option strategies.
When we talk about volatility we are referring to implied volatility. Implied volatility is forward looking and shows the “implied” movement in a stock’s future volatility. Basically, it tells you how traders think the stock will move. Implied volatility is always expressed as a percentage, non-directional and on an annual basis.
The higher the implied volatility the more people think the stock’s price will move. Stocks listed on the Dow Jones are value-stocks so a lot of movement is not expected, thus, they have a lower implied volatility. Growth stocks or small caps found on the Russell 2000, conversely, are expected to move around a lot so they carry a higher implied volatility.
When trying to decide if we are in a high volatility or low volatility market we always look towards the S&P 500 implied volatility, also known as the VIX. The average price of the VIX is 20, so anything above that number we would register as high and anything below that number we register as low.
When the VIX is above 20 we shift our focus into short options becoming net sellers of options, and we like to use a lot of short straddles and strangles, iron condors, and naked calls and put. The trick with selling options in high volatility is that you want to wait for volatility to begin to drop before placing the trades. Don’t short options as volatility is climbing. If you can be patient and wait for volatility to come in these strategies will pay off.
Short Strangles And Straddles
Short strangles and straddles involve selling a call and a put on the same underlying and expiration. The nice part about these strategies is that they are delta neutral or non-directional, so you are banking on the underlying staying within a range.
If you are running a short strangle you are selling your call and put on different strikes, both out of the money. The strangle gives you a wider range of safety. This means your underlying can move around more while still delivering you the full profit. The downside is that your profit will be limited and lower compared to a straddle and your risk will be unlimited.
To gain a higher profit but smaller range of safety you want to trade a short straddle. In this strategy you will sell your call and put on the same strike, usually at-the-money. Here you are really counting on the underlying to pin or finish at a certain price.
In both of these strategies you don’t need to hold till expiration. Once you see volatility come in your position should be showing a profit so go ahead and close out and take your winnings.
If you like the idea of the short strangle but not the idea that it carries with it unlimited risk then an iron condor is your strategy. Iron condors are setup with two out of the money short vertical spreads, one on the call side and one on the put side. The iron condor will give you a wide range to profit in if the underlying remains within your strikes and it will cap your losses.
The iron condor is our go to strategy when we see high volatility start to come in. The value in the options will come out quickly and leave you with a sizable profit in a short period of time. If, however, your prediction was wrong your losses will be capped so you don’t have to worry about blowing out your portfolio.
Naked Puts And Calls
Naked puts and calls will be the easiest strategy to implement but the losses will be unlimited if you are wrong. This strategy should only be run by the more experienced option traders. If you are bullish on the underlying while volatility is high you need to sell an out-of-the-money put option. This is a neutral to bullish strategy and will profit if the underlying rises or stays the same.
If you are bearish you need to sell an out-of-the-money call option. This is a neutral to bearish strategy and will profit if the underlying falls or stays the same. Both of these strategies should use out-of-the-money options. The further you go out-of-the-money the higher the probability of success but the lower the return will be.
When you see volatility is high and starting to drop you need to switch your option strategy to selling options. The high volatility will keep your option price elevated and it will quickly drop as volatility begins to drop. Our favorite strategy is the iron condor followed by short strangles and straddles. Short calls and puts have their place and can be very effective but should only be run by more experienced option traders.
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Strategies for Trading Volatility With Options
There are seven factors or variables that determine the price of an option. Of these seven variables, six have known values, and there is no ambiguity about their input values into an option pricing model. But the seventh variable—volatility—is only an estimate, and for this reason, it is the most important factor in determining the price of an option.
- The current price of the underlying – known
- Strike price – known
- Type of option (Call or Put) – known
- Time to the expiration of the option – known
- Risk-free interest rate – known
- Dividends on the underlying – known
- Volatility – unknown
- Options prices depend crucially on estimated future volatility of the underlying asset.
- As a result, while all the other inputs to an option’s price are known, people will have varying expectations of volatility.
- Trading volatility therefore becomes a key set of strategies used by options traders.
Historical vs. Implied Volatility
Volatility can either be historical or implied; both are expressed on an annualized basis in percentage terms. Historical volatility is the actual volatility demonstrated by the underlying over a period of time, such as the past month or year. Implied volatility (IV), on the other hand, is the level of volatility of the underlying that is implied by the current option price.
Implied volatility is far more relevant than historical volatility for options’ pricing because it looks forward. Think of implied volatility as peering through a somewhat murky windshield, while historical volatility is like looking into the rearview mirror. While the levels of historical and implied volatility for a specific stock or asset can be and often are very different, it makes intuitive sense that historical volatility can be an important determinant of implied volatility, just as the road traversed can give one an idea of what lies ahead.
All else being equal, an elevated level of implied volatility will result in a higher option price, while a depressed level of implied volatility will result in a lower option price. For example, volatility typically spikes around the time a company reports earnings. Thus, the implied volatility priced in by traders for this company’s options around “earnings season” will generally be significantly higher than volatility estimates during calmer times.
Volatility, Vega, and More
The “Option Greek” that measures an option’s price sensitivity to implied volatility is known as Vega. Vega expresses the price change of an option for every 1% change in volatility of the underlying.
Two points should be noted with regard to volatility:
- Relative volatility is useful to avoid comparing apples to oranges in the options market. Relative volatility refers to the volatility of the stock at present compared to its volatility over a period of time. Suppose stock A’s at-the-money options expiring in one month have generally had an implied volatility of 10%, but are now showing an IV of 20%, while stock B’s one-month at-the-money options have historically had an IV of 30%, which has now risen to 35%. On a relative basis, although stock B has greater absolute volatility, it is apparent that A has had a bigger change in relative volatility.
- The overall level of volatility in the broad market is also an important consideration when evaluating an individual stock’s volatility. The best-known measure of market volatility is the CBOE Volatility Index (VIX), which measures the volatility of the S&P 500. Also known as the fear gauge, when the S&P 500 suffers a substantial decline, the VIX rises sharply; conversely, when the S&P 500 is ascending smoothly, the VIX will be becalmed.
The most fundamental principle of investing is buying low and selling high, and trading options is no different. So option traders will typically sell (or write) options when implied volatility is high because this is akin to selling or “going short” on volatility. Likewise, when implied volatility is low, options traders will buy options or “go long” on volatility.
Based on this discussion, here are five options strategies used by traders to trade volatility, ranked in order of increasing complexity. To illustrate the concepts, we’ll use Netflix Inc (NFLX) options as examples.
Buy (or Go Long) Puts
When volatility is high, both in terms of the broad market and in relative terms for a specific stock, traders who are bearish on the stock may buy puts on it based on the twin premises of “buy high, sell higher,” and “the trend is your friend.”
For example, Netflix closed at $91.15 on January 29, 2020, a 20% decline year-to-date, after more than doubling in 2020, when it was the best performing stock in the S&P 500. Traders who are bearish on the stock can buy a $90 put (i.e. strike price of $90) on the stock expiring in June 2020. The implied volatility of this put was 53% on January 29, 2020, and it was offered at $11.40. This means that Netflix would have to decline by $12.55 or 14% from current levels before the put position becomes profitable.
This strategy is a simple but expensive one, so traders who want to reduce the cost of their long put position can either buy a further out-of-the-money put or can defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread. Continuing with the Netflix example, a trader could buy a June $80 put at $7.15, which is $4.25 or 37% cheaper than the $90 put. Or else the trader can construct a bear put spread by buying the $90 put at $11.40 and selling or writing the $80 put at $6.75 (note that the bid-ask for the June $80 put is $6.75 / $7.15), for a net cost of $4.65.
Write (or Short) Calls
A trader who is also bearish on the stock but thinks the level of IV for the June options could recede could consider writing naked calls on Netflix in order to pocket a premium of over $12. The June $90 calls were trading at $12.35/$12.80 on January 29, 2020, so writing these calls would result in the trader receiving a premium of $12.35 (i.e. the bid price).
If the stock closes at or below $90 by the June 17 expiration of the calls, the trader would keep the full amount of the premium received. If the stock closes at $95 just before expiration, the $90 calls would be worth $5, so the trader’s net gain would still be $7.35 (i.e. $12.35 – $5).
The Vega on the June $90 calls was 0.2216, so if the IV of 54% drops sharply to 40% soon after the short call position was initiated, the option price would decline by about $3.10 (i.e. 14 x 0.2216).
Note that writing or shorting a naked call is a risky strategy, because of the theoretically unlimited risk if the underlying stock or asset surges in price. What if Netflix soars to $150 before the June expiration of the $90 naked call position? In that case, the $90 call would be worth at least $60, and the trader would be looking at a whopping 385% loss. In order to mitigate this risk, traders will often combine the short call position with a long call position at a higher price in a strategy known as a bear call spread.
Short Straddles or Strangles
In a straddle, the trader writes or sells a call and put at the same strike price in order to receive the premiums on both the short call and short put positions. The rationale for this strategy is that the trader expects IV to abate significantly by option expiry, allowing most if not all of the premium received on the short put and short call positions to be retained.
Again using the Netflix options as an example, writing the June $90 call and writing the June $90 put would result in the trader receiving an option premium of $12.35 + $11.10 = $23.45. The trader is banking on the stock staying close to the $90 strike price by the time of option expiration in June.
Writing a short put imparts on the trader the obligation to buy the underlying at the strike price even if it plunges to zero while writing a short call has theoretically unlimited risk as noted earlier. However, the trader has some margin of safety based on the level of the premium received.
In this example, if the underlying stock Netflix closes above $66.55 (i.e. strike price of $90 – premium received of $23.45), or below $113.45 (i.e. $90 + $23.45) by option expiry in June, the strategy will be profitable. The exact level of profitability depends on where the stock price is by option expiry; profitability is maximum at a stock price by the expiration of $90 and reduces as the stock gets further away from the $90 level. If the stock closes below $66.55 or above $113.45 by option expiry, the strategy would be unprofitable. Thus, $66.55 and $113.45 are the two break-even points for this short straddle strategy.
A short strangle is similar to a short straddle, the difference being that the strike price on the short put and short call positions are not the same. As a general rule, the call strike is above the put strike, and both are out-of-the-money and approximately equidistant from the current price of the underlying. Thus, with Netflix trading at $91.15, the trader could write a June $80 put at $6.75 and a June $100 call at $8.20, to receive a net premium of $14.95 (i.e. $6.75 + $8.20). In return for receiving a lower level of premium, the risk of this strategy is mitigated to some extent. This is because the break-even points for the strategy are now $65.05 ($80 – $14.95) and $114.95 ($100 + $14.95) respectively.
Ratio writing simply means writing more options that are purchased. The simplest strategy uses a 2:1 ratio, with two options, sold or written for every option purchased. The rationale is to capitalize on a substantial fall in implied volatility before option expiration.
A trader using this strategy would purchase a Netflix June $90 call at $12.80, and write (or short) two $100 calls at $8.20 each. The net premium received in this case is thus $3.60 (i.e. $8.20 x 2 – $12.80). This strategy can be considered to be the equivalent of a bull call spread (long June $90 call + short June $100 call), and a short call (June $100 call). The maximum gain from this strategy would accrue if the underlying stock closes exactly at $100 shortly before option expiration. In this case, the $90 long call would be worth $10 while the two $100 short calls would expire worthlessly. The maximum gain would, therefore, be $10 + premium received of $3.60 = $13.60.
Ratio Writing Benefits and Risks
Let’s consider some scenarios to evaluate the profitability or risk of this strategy. What if the stock closes at $95 by option expiry? In this case, the $90 long call would be worth $5 and the two $100 short calls would expire worthlessly. The total gain would, therefore, be $8.60 ($5 + net premium received of $3.60). If the stock closes at $90 or below by option expiry, all three calls expire worthlessly and the only gain is the net premium received of $3.60.
What if the stock closes above $100 by option expiry? In this case, the gain on the $90 long call would be steadily eroded by the loss on the two short $100 calls. At a stock price of $105, for example, the overall P/L would be = $15 – (2 X $5) + $3.60 = $8.60
Break-even for this strategy would thus be at a stock price of $113.60 by option expiry, at which point the P/L would be: (profit on long $90 call + $3.60 net premium received) – (loss on two short $100 calls) = ($23.60 + $3.60) – (2 X 13.60) = 0. Thus, the strategy would be increasingly unprofitable as the stock rises above the break-even point of $113.60.
In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the same expiration, hoping to capitalize on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options.
The iron condor is constructed by selling an out-of-the-money (OTM) call and buying another call with a higher strike price while selling an in-the-money (ITM) put and buying another put with a lower strike price. Generally, the difference between the strike prices of the calls and puts is the same, and they are equidistant from the underlying. Using Netflix June option prices, an iron condor would involve selling the $95 call and buying the $100 call for a net credit (or premium received) of $1.45 (i.e. $10.15 – $8.70), and simultaneously selling the $85 put and buying the $80 put for a net credit of $1.65 (i.e. $8.80 – $7.15). The total credit received would, therefore, be $3.10.
The maximum gain from this strategy is equal to the net premium received ($3.10), which would accrue if the stock closes between $85 and $95 by option expiry. The maximum loss would occur if the stock at expiration is trading above the $100 call strike or below the $80 put strike. In this case, the maximum loss would be equal to the difference in the strike prices of the calls or puts respectively less the net premium received, or $1.90 (i.e. $5 – $3.10). The iron condor has a relatively low payoff, but the tradeoff is that the potential loss is also very limited.
The Bottom Line
These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility. Since most of these strategies involve potentially unlimited losses or are quite complicated (like the iron condor strategy), they should only be used by expert options traders who are well versed with the risks of options trading. Beginners should stick to buying plain-vanilla calls or puts.
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