QQQQ/SPY Imp Volatility considerations with a mean reversion swing system

J

J-Law

If one were to trade a mean reversion swing trading system
with a length of holding time of 7-10 days using OTM/ATM/ITM options, how would Imp vol impact the long side of this trade?

For starters & comparison...If I sell the rally, getting long puts
I would have both price & an increase in IV in my favor on the trade as the mkt sold off, thus increasing put premiums.

But what about on the long side?

Getting long calls on a dip? Price movement would still be in my favor. However, wouldn't one be entering the trade after
a sell off, which would pump up the IV, leading one to pay up for call premium & only have IV deflate as the mkt rallies. Thus, leading to less profit appreciation in the trade regardless of price movement?

Any ideas to remedy while still being long call premium to advantage the upside rally?

Yes, this is what one thinks about laying in
bed on a Sunday morning on a beautiful Forth of July weekend.
The game is always in play. I'm sure you agree.

:)
 
Quote from J-Law:

If one were to trade a mean reversion swing trading system
with a length of holding time of 7-10 days using OTM/ATM/ITM options, how would Imp vol impact the long side of this trade?

For starters & comparison...If I sell the rally, getting long puts
I would have both price & an increase in IV in my favor on the trade as the mkt sold off, thus increasing put premiums.

But what about on the long side?

Getting long calls on a dip? Price movement would still be in my favor. However, wouldn't one be entering the trade after
a sell off, which would pump up the IV, leading one to pay up for call premium & only have IV deflate as the mkt rallies. Thus, leading to less profit appreciation in the trade regardless of price movement?

Any ideas to remedy while still being long call premium to advantage the upside rally?

Yes, this is what one thinks about laying in
bed on a Sunday morning on a beautiful Forth of July weekend.
The game is always in play. I'm sure you agree.

:)
More...


If you are trading mean reversion in options with a long bias then its you're probably better off selling puts in order to take advantage of IV deflation.
Of course the mere mention of selling naked puts outrages many traders with many horror stories to tell about that strategy but as long as you don't go crazy as far as leverage and you have a real edge then selling an option is no more riskier than buying one.
The more OTM your option is the more impact a change in IV will have so buying OTM calls on sell-offs makes no sense as the subsequent IV deflation on the rally will greatly limit your profits.
 
Yes, after doing some Googling I have come to that conclusion as well. I am not adverse to selling put premium, as that makes a great deal of sense. SHort gamma in a falling IV situation. However, the acct I set to trade in has a short option limitation/resriction as it's an IRA acct.

I have been reading that deep ITM calls on a dip might be an alternative as they have less sensitivity to IV changes.

What do you think?
 
Quote from J-Law:

Getting long calls on a dip? Price movement would still be in my favor. However, wouldn't one be entering the trade after
a sell off, which would pump up the IV, leading one to pay up for call premium & only have IV deflate as the mkt rallies. Thus, leading to less profit appreciation in the trade regardless of price movement?

Any ideas to remedy while still being long call premium to advantage the upside rally?
More...
Yup, with an IV deflation you might even lose on your calls despite a nice bounce. Here's a cherry picked May example for the SPX. Looking at an IVolatility chart, IV peaked about 5/20 with SPX closing at 1071+. Over the next week, SPX bounced 30+ pts but IV contracted about 10 BPs. I doubt that an ATM call would have made much, if anything. ATM would have fared much better but then your exposure is significantly more if your reversion fails to materialize.

Selling some premium in a wide vertical would reduce your long call vega exposure but it's a guessing game as to how much benefit that adds because there are so many moving parts (subsequent UL price & IV change, time decay) as well as the limiting nature of the short calls to the upside. With ATM, you'd most likely do better with the vertical unless IV reflated again.

It's a bit of work but looking at some historical data might get you closer to an answer.
 
Quote from J-Law:

If one were to trade a mean reversion swing trading system
with a length of holding time of 7-10 days using OTM/ATM/ITM options, how would Imp vol impact the long side of this trade? ...
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... Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility. Volatility is a huge component of an option’s extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.


As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less. Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the spread.


So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.


As to how to set it up, you would follow the same guidelines as you would for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.


Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the spread will have to be constructed with the short option being the at-the-money. ...
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... :)
 
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