OTM call spreads vs OTM put spreads on very high IV

[JackRab]

Can anyone shed some more light on the following?

If IV is extremely high, say way above 100, what usually happens is that the IV-curve across strikes flattens, skew gets less. The result is that OTM calls are relatively more expensive than OTM puts. Now, usually this is the other way around, since skew makes puts more expensive than calls.

I would say this happens because the distribution curve starts to be abnormal, with more weight to the upside... since there's unlimited upside on stock moves and limited to -100% to the downside. So it makes sense to have calls worth more than puts on very high IV.

But... often extreme IV happens in a boom/bust kinda scenario, or with stocks that move a lot on earnings releases. Which is a jump-scenario instead of a gradual large moves. So expectancy of say 40% move up or down. Still, higher value for calls compared to puts makes some sense.

But the consequence is also that OTM call spreads are a lot more CHEAPER than OTM put spreads....

So while puts seem cheap, the put spreads are actually expensive...

A 10-20% OTM call spread can be the same value as the 30-40% OTM put spread.... Which somehow doesn't seem right to me in case of a jump scenario....

Any thoughts?

 

[Robert Morse]

If the OTM calls are materially higher than the OTM puts, the uncertainty and risk of the unknown is on the upside. This can happen on stocks with an upcoming binary events like a biotech with FDA news or takeover rumors.

This can also happen in the option skew of some commodities when the risk of a tail event is a disruption of supply. When you use the term "CHEAPER", you are implying that their is value in "fighting" the skew, that it must be wrong because other equity options don't trade that way. You are making the assumption that there is some reversion to the mean that will occur.

Not sure if that is the best way to play these set ups.

 

[sle]

Actually, in case of extreme vol, it's just an artifact of lognormal assumption, because the spreads are an approximation to a binary (probability) bet. It's for the same reason as ATMF straddle will not be exactly delta neutral (it's gonna have a little bit of delta to put).

 

[JackRab]

@Robert Morse,

No, I'm talking about the OTM call spread vs OTM put spread... so not calls or puts on it's own.

I totally get the risk to the upside since unlimited up as I said before. But this would be less on a jump. A one time event...

And even then, with spot at 100 and high IV of say 180... the 130-140 call spread is worth $2 and the 70-60 put spread about $3 (no skew, IV of 180 across all strikes). So even if you expect unlimited upside risk... (mind you, in this case the straddle is only about 40% of spot).... the call spread is cheaper, while bigger/same chance of ITM!

(@sle, with high IV the straddle actually has a positive delta, so delta to the call... to account for upside unlimited risk)

 

[Robert Morse]

It is not clear to me that using a flat skew is providing you an edge worth exploiting in that way, and that the current skew is not correct. My only point is that just because an option trades with a higher than the market IV, you can't assume it is "high", it might be too low!

Do you have a real life current example of a stock with a "high" IVOL-again making an assumption it is higher than where it should be-and where you see value and why? Then what trade you would do and at what price. Then where would you look to exit if you are wrong or right?

 

[sle]

(@sle, with high IV the straddle actually has a positive delta, so delta to the call... to account for upside unlimited risk)

Typo on my side. It's always slightly to call - as you increase the vol, delta imbalance will increase.

 

[xandman]

So when hell breaks loose, hedge dynamically with fairly priced ATM options!?.?

As you sell off your long vol inventory, of course.

 

[JackRab]

So when hell breaks loose, hedge dynamically with fairly priced ATM options!?.?

As you sell off your long vol inventory, of course.

?

What are you ranting about? Who said anything about hedging and long vol inventories...

 

[xandman]

You exit long vols at a profit obviously. I assumed you were worried about a short call spread maintaining it's value after a crash. Are you just basking in the theory?

 

[JackRab]

It is not clear to me that using a flat skew is providing you an edge worth exploiting in that way, and that the current skew is not correct. My only point is that just because an option trades with a higher than the market IV, you can't assume it is "high", it might be too low!

Do you have a real life current example of a stock with a "high" IVOL-again making an assumption it is higher than where it should be-and where you see value and why? Then what trade you would do and at what price. Then where would you look to exit if you are wrong or right?

Again, I'm not saying high IV is higher than were it should be. On the contrary, I'm more inclined to buy high vol gamma because it's there for a reason..

But... again, can anyone shed some light on why it seems that a 10-dollar call spread 30% OTM is worth less than a 10 dollar put spread, also 30% OTM....

When you take the viewpoint that the value of the spread is the chance it has to become ITM, so the 130-140 CS is $2... hence 20% chance... (not my exact view, but it's been mentioned here on ET that that's the way some look at it)... the similar 60-70 PS (both 30% out) is $3, so 30%...
When we agree risk is to the upside, than there should be a bigger chance to the upside.. or am I mistaken? The 130 call would have a higher value than the 70 put as well to back this up...