Wednesday, November 11, 2009

Volatility Skew and SPY Ratio Spread Update

In my post highlighting the volatility skew of SPY options, I introduced the idea of selling ratio spreads to exploit the skew as well as profit from a mildly bearish move in the underlying. You can view the post here. Fast forward two weeks, mix in a robust rally in the SPY as well as diminishing volatility, and what do we have? While I let the suspense build, let's recap the numbers from trade inception:

Oct. 28th, SPY @ $104
Buy (1) Nov 103 put for $2.00
Sell (2) Nov 100 puts for $2.40 ($1.20 apiece)
Net Credit = $.40

Take a gander at the risk graph from trade entry (click image to enlarge):

[Source: EduTrader]

Here is the current risk graph:

So what do we have? Due primarily to the rally in the SPY and partially to the declining volatility (VIX dropping from 31 to 23), the puts in play are far OTM and almost worthless. At this point we have three options:

1. Close the trade to lock in the majority of the net credit (roughly $.30)
2. Ride to expiration in an effort to realize the entire net credit (occurs if SPY remain above $103)
3. Ride to expiration in the hopes that the SPY drops below $103 into my "larger" profit zone.

The outcome of this particular trade sheds insight into one big advantage of the 1x2 put spread. Even though the SPY have risen considerably (the WRONG way), we were still able to garner a mild profit on the trade.

EDIT: By the "WRONG" way, I simply mean the direction that does not result in what I consider the ideal or largest profit.

For related posts, readers are encouraged to view the following:

3 comments:

Mark Wolfinger said...

Tyler,

I want to share my opinion.

After more than 20 years of trading these ratio spreads (haven't used them in a long time), I believe that SPY has moved the RIGHT way, not the wrong way.

Sure, a right-sized decline earns extra profits, but that's a very unlikely occurrence. SPY must finish not much under 97 and below 103 to earn a bigger profit.

That's a tiny zone with the possibility of a disaster staring you in the face.

I'll take the 40 cent credit and the rally every time. The rally is the RIGHT direction as far as I am concerned.

Regards

Tyler Craig said...

Hey Mark,

Thanks for the comment and good point. I suppose by saying "wrong" way, I meant the way that doesn't result in the largest or ideal profit. I should probably be more clear on that.

Here's my take: If my goal was to simply receive the credit (I want the stock to increase), why not just do a different bullish trade such as a selling put spreads? If a trader was of the opinion that keeping the credit received was the "ideal", I'd say why bother with the 1x2 put spread in the first place? Go play put spreads or something that has more upside. (Which is probably why you don't currently play the ratio spread, but instead opt for your condor + insurance approach)

Based on my experience with them so far, they've "seemed" like a decent method for placing a mildly bearish bet.

As we've both mentioned though, the large downside risk is the obvious caveat that can't be forgotten for anyone playing these.

Mark Wolfinger said...

Right. Don't forget the risk.

That's the bottom line.