Wednesday, April 28, 2010

Volatility Spike and Ratio Spreads

Yesterday's monster sell off ushered in a notable resurgence in fear. With a 30+% spike in the VIX, there certainly seemed to be a mad dash toward buying option premium. The 64K question is whether or not this upturn in volatility is a "one hit wonder" soon to subside, or whether it's a clarion call to the bears to come out from hibernation and start wreaking havoc on the market. No doubt time will tell which scenario ends up playing out. It will be interesting to see over the remainder of the week whether or not we get some significant follow through to the downside.

Provided Tuesday's sell off is a short lived event, the volatility ramp up is certainly providing some compelling opportunities. In Volatility Skew and Ratio Spreads I explored volatility skew and how to use ratio spreads to take advantage of potentially overpriced downside puts. Let's take a renewed look at the vol skew that has elevated over the last few days and construct a potential ratio spread.

A quick assessment of the SPY option chain shows lower strike puts trading at higher implied volatility levels than higher strike puts. From a volatility perspective we prefer to buy options trading at lower volatility levels and sell those trading at higher volatility levels.
We may consider structuring a ratio spread to exploit the relatively expensive OTM puts. Suppose we purchase a May 117 put for $150 and simultaneously short three May 113 puts for $240 ($80 x 3). Consider the risk graph below:

[Source: MachTrader]

The blue, red, and green lines display the affect of declining volatility. The upward shift shows the positive effect this could have on the trade. When entering a ratio spread, traders can modify the risk-reward by changing the ratio of long to short options. While some trader may opt to do a 1 x 2 spread, others may prefer a 1 x 3 spread. At the end of the day you need to assess the risk graph to ensure your comfortable with the potential risk inherent to the trade. While shorting 3 puts for every 1 you purchase offers a higher net credit, it also possesses more downside risk due to the additional short puts.

For related posts, readers can check out:
Larry McMillan on Volatility
Volatility Skew and SPY Ratio Spread Update
Gaming the Sell-off with Put Ratio Spreads

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