Credit Put Spread.. ATM vs OTM

[newwurldmn]

Yes sir. But I am still learning. Most of the time I made money placing directional bets and some of you would certainly say it is like going to Las Vegas.

Thinking out loud, if I short volatility (sell calls), I should buy some volatility to cap my risk, so that means a spread?

Frankly I tried everything else: Took profits/losses early, took partial profits/losses, roll up, roll down, roll out, roll in, convert into calendar, diagonal spreads... The bottom line is it is still a judgement call as I have not found any automated formula. So now I am writing my own software program to try quantify all the possibilities and their consequences....Very difficult for someone without any finance background, even with just the basic Black Scholes.

I always appreciate your replies to my posts, they clarified a lot of my questions.

Regards,

Focus on forecasting volatility. If you can say that its likely volatility next month will be 30, and the option is being bid at 45. Sell the option and try to capture 15 vols. If the option is being bid at 33 vol, maybe you don't want to sell it.

 

[ironchef]

Focus on forecasting volatility. If you can say that its likely volatility next month will be 30, and the option is being bid at 45. Sell the option and try to capture 15 vols. If the option is being bid at 33 vol, maybe you don't want to sell it.

Thanks. I will remember that.

 

[ironchef]

Hi all. I am curious the thoughts of the board on the logic behind perpetually selling credit put spreads atm vs otm. I see research citing IV is overstated by 3 vol points compared to realized vol. See the link below.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2579232

This is why option sellers overtime beat option buyers. Everyone knows this. My question though is how to best exploit this. I understand there is skew and selling a spread at higher vol is better than lower vol, given identical underlyer, so this possible favors otm. But since vega peaks atm, wouldn't it be best to "take" these 3 points with vega at it highest possible value? It would lead me to believe selling put spreads atm would be more profitable than selling them 5 or 10% otm.

Any thoughts on the matter are greatly appreciated!

*I am not saying this is a great strategy, especially with low vol, but I am more interested in the theory on how markets work.

My apology for our side track from your original posts and the points you were trying to make: There is a volatility premium and so selling options can in general capture this premium and profit from it and that selling beats buying in the long term. The paper you quoted used VIX as a proxy for IV and comparing VIX to HV showing there was indeed a premium.

I don't know the composition of VIX so cannot comment on whether VIX is a good proxy for IV. I can however obtained the IV for SPY and compare it to HV. I can also compare IV to VIX to see if the shape are equivalent. Here are the charts:

And indeed VIX has exactly the same shape as IV Call (which from put/call parity = IV Put). What puzzles me is I just don't see the risk premium when I compare IV to HV as shown in the second chart. So, where do I go wrong? Or how accurate is VIX as an equivalent to IV?

Also, from the CBOE websites, comparing selling calls and selling puts to SPY, the excess returns were meager and just don't seem to be worth 2 to 4 percentage points of volatility to me.

Do you have any insights you can share with us? Thanks.

 

[Herkfsu]

What strike and DTE was the 'IV Calls' in your photo?

From the study linked...

The most common ex post value measure for put options is the Volatility Risk Premium, which is option implied volatility, as proxied by the VIX Index level, minus the S&P 500’s realized volatility over the coincident period. Exhibit 3 plots the Volatility Risk Premium over the period January 2, 1990 through June 30, 2014 in which VIX Index data is available. Over this period, the volatility risk premium has averaged +3.4% and has been positive 88% of the time.4 Investors who heed analysts’ recommendation to purchase options are not only long volatility – they also face long odds of benefiting from the option purchase.

 

[ironchef]

What strike and DTE was the 'IV Calls' in your photo?

From the study linked...

The most common ex post value measure for put options is the Volatility Risk Premium, which is option implied volatility, as proxied by the VIX Index level, minus the S&P 500’s realized volatility over the coincident period. Exhibit 3 plots the Volatility Risk Premium over the period January 2, 1990 through June 30, 2014 in which VIX Index data is available. Over this period, the volatility risk premium has averaged +3.4% and has been positive 88% of the time.4 Investors who heed analysts’ recommendation to purchase options are not only long volatility – they also face long odds of benefiting from the option purchase.

View attachment 168365

According to my brokerage, the IV is the average call IV for that date on the chart and was not tied to a specific strike and DTE. The IV for put is almost identical. The HV is historical volatility (actual) as defined by the standard deviation of SPY for the period specified, both normalized so they claimed comparing apple to apple.

Take your statement at face value, for SPY today, the 30 day Call options pays $20.5 per share with an IV of ~9%. If the actual IV is 9-3.4 or 5.6% The premium would be ~$13. So the risk premium is 4.6% annualized over the index value. The index's annualized returned for the past 20 yrs was 9.4%. To compare apple to apple, I have to put the money not investing in options in a risk free T bill which returned ~3% so the total return is 7.6%. How is it better than buy and hold?

However, I am not sure I make sense.

 

[ironchef]

Herkfsu,

First of all, I am not here to argue, just try very hard to understand all the subtleties of options so please don't be offended.

I went back to the CBOE site and read their definition of VIX:

The CBOE Volatility Index® (VIX)® is based on the S&P 500® Index (SPX), the core index for U.S. equities, and estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. By supplying a script for replicating volatility exposure with a portfolio of SPX options, this new methodology transformed VIX from an abstract concept into a practical standard for trading and hedging volatility. In 2014 CBOE enhanced the VIX Index to include series of SPX Weekly options. The inclusion of SPX Weeklys allows the VIX Index to be calculated with S&P 500 Index option series that most precisely match the 30-day target timeframe for expected volatility that the VIX Index is intended to represent. Using SPX options with more than 23 days and less than 37 days to expiration ensures that the VIX Index will always reflect an interpolation of two points along the S&P 500 volatility term structure.

In other words, it looks at a 30 DTE options weighted average IV so the best comparison is to the 20 DTE HV. However, the calculation of HV is backward looking (std dev of the past 20 trading days) whereas VIX is forward looking. For a fair comparison, do I have to compare the IV of 20 trading days ago to the HV of today?

Your paper used a 21 days annualized SPX std dev. I don't know if they shifted back for a true forward/backward comparison. If not there could be a mismatch of data?

Do you have any insights into this?

Thanks.