Wednesday, October 28, 2009

Volatility Skew and Ratio Spreads

In the McMillan chat I referenced earlier, he talked about put ratio spreads on the SPY. Though I'm familiar with ratio spreads, I haven't used them that often in my own trading. The most recent instance being the 1x2 put spread mentioned in the Sept. post: Oil Triple Play Part I.

McMillan discussed the negative volatility skew that exists in SPY options where OTM puts trade at higher implied vol levels than ATM puts. To exploit the skew (i.e. buy options with lower implied vol while selling options with higher implied vol), the thought was to buy an ATM or slightly OTM put while simultaneously selling multiple further OTM puts. So instead of buying a run of the mill put vertical spread where you buy and sell an equal amount of contracts, the ratio spread involves selling more contracts than you own.

Take a look at the following SPY option chain:
[Source: EduTrader]

Notice how the IV increases as you move further OTM. Let's look at two put ratio spread examples.

SPY November 104-101 1x2 put spread
Long (1) Nov 104 put @ $2.55
Short (2) Nov 101 put @ $1.54
Net Credit = $.53
[Source: EduTrader]

If you wanted to widen the profit zone, rather than selling 2 of the same strike, you could sell 2 different OTM strike puts. For example:

Long (1) Nov 104 put @ $2.55
Sell (1) Nov 101 put @ $1.54
Sell (1) Nov 99 put @ $1.12
Net Credit = $.11

[Source: EduTrader]

Based on the risk graph, you can see it's basically a mildly bearish play. Ideal scenario is to have the stock sitting around the short strikes at expiration. Due to the additional naked short puts, there is downside risk if the SPY tanks. However, if you enter with a credit there isn't any upside risk, so there's a bit of a trade-off there. All in all I think it's a decent strategy to exploit overpriced OTM puts if you're mildly bearish.