Tuesday, January 26, 2010

Gaming the Selloff with Put Ratio Spreads

With the massive selling drying up a tad over the last two days and the SPX catching a bid, we've seen the VIX move predictably lower. So far so good for any one that chose to short volatility into the spike on Friday.

Speaking of fading the VIX- what types of strategies could a trader use when betting on a declining VIX?

If you were comfortable with the nuances of futures, you could certainly look to short VXX or enter bearish VIX option plays. For those reticent to try their hand at these more complex products, how about keeping it simple and playing with options on the SPY? There are quite a few short volatility strategies to choose from depending on your outlook.

In Adam Warner's recent post, Bernanke Ultimatum...And Some Skew, he mentioned a few observations from Ticonderoga Securities regarding the volatility skew that has arisen in various ETF options including the SPY. As mentioned in Volatility Skew and Ratio Spreads, vol skew occurs when further OTM put options trade at higher vol levels than ATM put options. To exploit the skew, Ticonderoga Securities suggested initiating a risk reversal by selling an OTM put option and simultaneously purchasing an OTM call option. While the risk reversal is a legit way to take advantage of the pumped up put options, what if a trader is unwilling to make a bullish bet? Any other short vol strategies that do well even if the SPY drops a bit further?

How about the good 'ole 1x2 put spread-

Take a look at the following SPY option chain paying close attention to the IV (implied vol) column. Notice how IV increases as the puts move further OTM. We could construct a 1 x 2 put spread by purchasing the Feb 104 put for $1.11 and selling two Feb 101 puts for $.67.



[Source: EduTrader]

The beauty of having a risk graph is you can play around with different strike prices and see the effect it will have on your risk-reward. I simply chose the Feb 104 and 101 puts as an example. If you wanted to receive more credit you could either tighten up the spread by decreasing the distance between the strikes (i.e. buy 104, sell 103) or by using higher strike puts.

The ideal scenario would be the SPY drift lower and reside around the short strikes (101) at expiration. The downside risk lies in the fact that you're shorting naked puts. While you want the underlying to move lower, if the decline in price gets too out of hand the losses can start to mount.

4 comments:

Tim Justice said...

Tyler,

Great Post!

You got me so interested with the ratio spread that I went and messed with risk graphs for a half hour looking at different constructions....I think a pure volatility play I'd rather use options in further out exp months....after factoring for a 3% volatility drop it looked like I had a better profit window and breakevens using options for June instead of Feb (and that's based on the same exiting target on the 19th of Feb which is expiration date.)

Do you have any guidelines on how you select strikes and months? How do you know to cut the trade out on a loss?

Just curious now....I'm going to get to work on this model

THanks!

Tim Justice

http://tradingimagination.blogspot.com

Tyler Craig said...

Hey Tim,

I've never really played much with further months, but based on what your saying it certainly seems like it may be a better option.

I typically choose strikes based off of how much credit I'm receiving and my outlook on the stock. So, it's kind of a case by case basis. If I'm more neutral to bullish I prefer to receive enough credit to make it worthwhile if the stock doesn't fall in value. If I'm more bearish, I don't mind receiving less credit since the stock may have a better chance to fall into the ideal profit zone.

As for stop losses, I haven't really had any go against me yet so I don't really have any experience of what works best.

At worst, I'm sure I'd bail before the short puts went ITM. I've yet to decide on ONE method, but have thought about just keeping it simple and bailing if I lose a certain percentage.

Jon & Gari said...

Tyler,
Interesting article and good food for thought.
I have yet to do a lot of these, but am inclined to say a simple percentage stop loss may be the way to go. My attempts to "fix" these with delta hedging have been a study in compromise. I end up trading to make half as much and what's the sense in that?
I will be paying closer attention to OTM vs. ATM volatility from now on; thanks for the eye-opener.
Jon

Tyler Craig said...

Yeah, sometimes you end up spinning your wheels and racking up commission when delta hedging. The 1x2 spread I highlighted has such a wide range of profit, I'd almost just chuck the trade if the market drops too much. The way the trade is setup, it pretty much takes care of itself as time passes.

If you decide to take the delta hedging route, your almost forced to start micromanaging everything.