capturing Volatility

[trading1]

Hi, What are the best ways of being exposed to downside volatility without paying a high premium for it? I am considering selling calls and using the funds to buy puts. Therefore it ought to be "free" in terms of the premium cost, and I'd lose in a rising (but therefore probably low volatility market) and gain in a falling (but probably high volatility) market?

Are there any other better alternatives? Thanks for any help.

 

[sle]

Quote from trading1:

Hi, What are the best ways of being exposed to downside volatility without paying a high premium for it?

There is no such thing as "the best way", if you are buying risk premium your either are going to bleed or be forced to sell some other form of risk premium against it (if, however, you do believe in free money and Santa Claus, please try the SJ options thread for some tasty snake oil recipes). Anyway, a few pointers:

(a) S&P skew is historically cheap at the moment, so it is probably the right time to enter a risk reversal (sell calls, buy puts). You do want to delta-hedge that position, otherwise you will have exposure to terminal distribution and not the realized volatility. Longer-dated skew will be more of a view on the correlation of implied volatility and spot, shorter more of a crash protection.

(b) If you believe in large moves to the downside and are willing to risk smaller downside moves, you can sell a 1x2 (or a 1xN) put spread, buying the wings and selling the ATM. Again, do it vs. a delta hedge. Your core risk is again timing, the gamma on the wings (as well as the protective nature of the position) will decay away pretty fast

(c) You can come up with some sort of reverse dispersion structure where you are selling ATM options in single stocks (essentially, underwriting the idiosyncratic risk) and use the proceeds to over-buy longer-dated lower-strike puts in S&P. A position like this is, in essence, a stock-picking exercise any way you'd structure it and it, by definition, will be very noisy.

Just my .25 vegas

 

[trading1]

Appreciate the informative reply.

< enter a risk reversal (sell calls, buy puts)>

Whats the cost in terms of premium in this trade? Does the gain from selling the calls negate the cost of the puts?

I’m not fond of delta hedging (though suppose I could get used to it) because of the “inverse gamma scalp”, when the trade mean reverts (as volatility does) I end up being short gamma and paying for it. I’d like to bypass the delta hedging on the basis that if I trade sufficiently OTM, then I expect I’d be trading with a higher ratio invested in the premium or realized volatility – is that right?

<“If you believe in large moves to the downside and are willing to risk smaller downside moves”>

That’s exactly what I want.

<“you can sell a 1x2 (or a 1xN) put spread”>

Pardon my ignorance, is this the same as a “bear put spread”? I don’t fully understand the ‘1x2” is that a weighting on downside wing?

<“reverse dispersion structure where you are selling ATM options in single stocks”>

Does this mean just selling the puts or both puts and calls?
Is the premise here (apart from the stock picking) that the IV on the spy will rise relative to the IV on the individual stocks as the market falls?

Thank you again for the insights.

 

[sle]

Whats the cost in terms of premium in this trade? Does the gain from selling the calls negate the cost of the puts?

You can either do it vega-neutral (in which case you going to start flattish gamma and neutral vega) or you can do it premium-neutral in which case you will start short gamma and short vega, since you have to seriously oversell the call leg. If you are planning to actively delta hedge it, you should do it vega neutral, if you are planning to keep this as a static hedge, you should do it premium neutral (but be ready that on a move up it will hurt).

I’m not fond of delta hedging (though suppose I could get used to it) because of the “inverse gamma scalp”, when the trade mean reverts (as volatility does) I end up being short gamma and paying for it. I’d like to bypass the delta hedging on the basis that if I trade sufficiently OTM, then I expect I’d be trading with a higher ratio invested in the premium or realized volatility – is that right?

You are betting that if the market is moving toward the lower strike, realized volatility will be higher then the average of the two implied vols on the two strikes and the opposite if the the market is moving up. I really can't see how a mean reverting move will get you to be short gamma, as long as you predicted the dynamics properly. A collar position without at least the initial delta is simply a short position on the market, you might as well just sell delta.

Pardon my ignorance, is this the same as a “bear put spread”? I don’t fully understand the ‘1x2” is that a weighting on downside wing?

It's a pretty standard lingo. E.g. with SPX at 1418, you would sell one Jan 1420 put and buy two Jan 1375 puts. Day one you would be pretty much flat delta (assuming you doing it more or less premium-neutral) and you will have a meaningful amount of dGamma/dSpot (or dVega/dSpot for longer dated versions) which is probably what you want.

Does this mean just selling the puts or both puts and calls?
Is the premise here (apart from the stock picking) that the IV on the spy will rise relative to the IV on the individual stocks as the market falls?

The are many ways you can structure a reverse dispersion position. Given what you are looking for (I take it it's the Mayan prophecy?), you want to sell ATM puts on cheap stocks with overpriced vol and buy OTM puts on the index resulting in a net market neutral initial position. The position has a few moving parts. On the move down, you will get longer index vega and gamma and shorter street vega and gamma. You are hoping that the implied correlation will increase resulting as you getting there, so you make money on the index leg faster then you are going to be losing on the single name legs.

Thank you again for the insights.

You are welcome. I suggest taking a simple black scholes spreadsheet and playing with these positions - in process, try to formulate an opinion of the dynamics of implied volatility.

 

[FrankSlaughtery]

+1 to what sle said re no free lunch. there is no way to have unlimited upside w/ no downside. the downside to having the opportunity to profit from a vol spike is you have to pay for it via premium.

as sle stated downside protection is cheap right now but only up to one year. i would not buy puts w/ expiry any later than dec 2013.

 

[cdcaveman]

i like the SJ options comment haha +1
ratio backspreads in either puts and calls i've traded.. i thought at first it might have been a superior strategy but i quickly found out that its just another tool to express your view.. putting on otm ratio backspreads can have the equivalent convexity of outright buying deepr otm puts.. and when you put on ratios your tying up margin.. As far as margin liabilities go your in a credit spread.. i actually have realized near the full loss in a ratio backspread. if you think about a five wide ratio. your tying 500 dollars up and usually paying a little differential.. unless your spreading your strike width even wider and taking on more margin risk which has a opportunity cost to it.. i personally think to myself .. why take on additional complexities when i'm just trying to express the idea that puts will be over priced relative to the forward.. simply buy a deep otm put.. thats more the holy grail of options then anything else.. that you can simply express yourself on direction in a very leveraged and limited risk way..
btw if your talking dispersion SLE doesn't everything more or less correlate in a crash? turning that noise into it a clean correlation of hurt?

 

[Jgills]

Quote from cdcaveman:

i like the SJ options comment haha +1
ratio backspreads in either puts and calls i've traded.. i thought at first it might have been a superior strategy but i quickly found out that its just another tool to express your view.. putting on otm ratio backspreads can have the equivalent convexity of outright buying deepr otm puts.. and when you put on ratios your tying up margin.. As far as margin liabilities go your in a credit spread.. i actually have realized near the full loss in a ratio backspread. if you think about a five wide ratio. your tying 500 dollars up and usually paying a little differential.. unless your spreading your strike width even wider and taking on more margin risk which has a opportunity cost to it.. i personally think to myself .. why take on additional complexities when i'm just trying to express the idea that puts will be over priced relative to the forward.. simply buy a deep otm put.. thats more the holy grail of options then anything else.. that you can simply express yourself on direction in a very leveraged and limited risk way..
btw if your talking dispersion SLE doesn't everything more or less correlate in a crash? turning that noise into it a clean correlation of hurt?

why would the correlation hurt you? you're selling expensive vol (stock) and buying cheaper vol (index) and you're doing it in a ratio. i think the worst case in a crash would be that the stock ends up going bankrupt and the index doesn't drop enough to cover it.

 

[cdcaveman]

Quote from Jgills:



why would the correlation hurt you? you're selling expensive vol (stock) and buying cheaper vol (index) and you're doing it in a ratio. i think the worst case in a crash would be that the stock ends up going bankrupt and the index doesn't drop enough to cover it.

(c) You can come up with some sort of reverse dispersion structure where you are selling ATM options in single stocks (essentially, underwriting the idiosyncratic risk) and use the proceeds to over-buy longer-dated lower-strike puts in S&P. A position like this is, in essence, a stock-picking exercise any way you'd structure it and it, by definition, will be very noisy.

i really was way off there wasn't I... i know in a crash things correlate highly.. and that helps alot when convergence trading in pairs, or constituents verse index.. i wasn't thinking clearly..
i'm not sure if he ment short straddles/butterfly in single names against puts in the index in ratio or what..
my thoughts would be a little long delta in good names in flys.. and long deep otm puts .. structuring the strike space/ correlation / and ratio.. seems like alot of assumptions .. especially for someone who barely knows the vocab haha