SPX Credit Spread Trader

[rallymode]

Quote from optioncoach:

I know we are speculating, but even without a model I have to disagree that a 20 call would stay under $1.00 with a few weeks to expiration and the VIX spiked to 60. Those calls have to have some value in line with the VIX move although it will not be 1:1.

Then why are there no bids on the vix 10 puts? Just like the MM's are pricing the puts for no sure/easy money they will do the same if the vix spikes to 60.

The calls will have value in line(purchase value that is) but MM's will probably keep the bids very close to $0. If i have to guess i'd say anywhere between $0 and $2 or $3 would be reasonable to eliminate arbitrage.

But if bids exist, i tend to think that longer term options will still be priced higher i.e. have higher bids, again to eliminate arbitrage. Therefore, longer term options would be a better insurance that is if the hedge works and u can get out at intrinsic.

 

[El OchoCinco]

Well we are going in speculative circles here

The 10 Puts are OTM, they are not the same as 20 strike calls when the VIX has spiked to 60.

I also doubt strongly that a 20 Call with the VIX at 60 will have a bid at $0 being that far ITM.

Longer-term options having higher bids would go against your theory that VIX should fall after a spike. Longer-term options would not move that much since they would expect VIX to move back before their expiration date if the options are like 6 months out. So I cannot see how 1 month option would have a bid of $0 and a 6 month option would have a bid at intrinsic value.

Again, I can see no logic at all that supports a 20 Call being worthless to sell with the VIX at 60. If all current options are selling at intrinsic plus time value, why would a sharp rise in VIX cause the intrinsic values to go to $0 on a deep ITM call?

As I said before, there are spot forex and forward forex rates. Forwards trade at slight premiums and discounts. If an event caused spot rates to jump, are you saying that forward rates would not jump at all because of an expectation that the rates will come back down. The VIX option is based on a 30-day forward expectation of the VIX value. If VIX spikes to 60, I cannot imagine that the trading world will keep their 1 month value of expectation at 20 or so from where it jumped.

We will not get an answer I guess since this is theoretical but it goes against all my option logic (hear the laughter as I say that) that just because VIX pulls back after spikes that the front-month options are not going to have intrinsic values.

Quote from rallymode:

Then why are there no bids on the vix 10 puts? Just like the MM's are pricing the puts for no sure/easy money they will do the same if the vix spikes to 60.

The calls will have value in line(purchase value that is) but MM's will probably keep the bids very close to $0. If i have to guess i'd say anywhere between $0 and $2 or $3 would be reasonable to eliminate arbitrage.

But if bids exist, i tend to think that longer term options will still be priced higher i.e. have higher bids, again to eliminate arbitrage. Therefore, longer term options would be a better insurance that is if the hedge works and u can get out at intrinsic.

 

[rallymode]

Again, i am not saying they will have no values, i am saying that they will have no bids or very small bids. As the VIX starts to move sharply i see the bids increasing initially but once they reach a certain level, which i am speculating it will be around $2-3 then after that only asks will increase with the VIX value. Thus, u cant get out of the position for the profit you are seeking.

I am still running strategies in my head but i simply cannot see the bids skyrocketing with the VIX simply because of arbitrage.
If the normal option pricing model applies after the market crash event the way you expect it to, i see MANY oportunities to make easy money and i have been around long enough to be sceptical when faced with such a picture. (calendars, bear call spreads, bull put spreads, short futures with protective call, synthetics, reversal, and a few others would be very profitable)

Also, the longer term options being worth less than the short term isnt MY theory, its what the CBOE is basically telling us in their #5 specification. Which i doubt because of arbitrage. I think they will be worth as much as the near term ones or more, but not less cuz then calendars would be arb trades.

We can do this all day, but my head is spinning. I need a beer or something.

 

[El OchoCinco]

Gonna call Jessica and see if she is free for a drink myself....

Quote from rallymode:

Again, i am not saying they will have no values, i am saying that they will have no bids or very small bids. As the VIX starts to move sharply i see the bids increasing initially but once they reach a certain level, which i am speculating it will be around $2-3 then after that only asks will increase with the VIX value. Thus, u cant get out of the position for the profit you are seeking.

I am still running strategies in my head but i simply cannot see the bids skyrocketing with the VIX simply because of arbitrage.
If the normal option pricing model applies after the market crash event the way you expect it to, i see MANY oportunities to make easy money and i have been around long enough to be sceptical when faced with such a picture. (calendars, bear call spreads, bull put spreads, short futures with protective call, synthetics, reversal, and a few others would be very profitable)

Also, the longer term options being worth less than the short term isnt MY theory, its what the CBOE is basically telling us in their #5 specification. Which i doubt because of arbitrage. I think they will be worth as much as the near term ones or more, but not less cuz then calendars would be arb trades.

We can do this all day, but my head is spinning. I need a beer or something.

 

[Cache Landing]

You guys have a pretty good discussion going and I don't want to interrupt, but.....

From where I stand, I've never seen a situation with options that an ITM strike with no bids couldn't still be sold if you drop your ask under intrinsic value. I have been in a couple situations where after an ER I found myself DEEP ITM and had to drop to 0.05 under intrinsic to get filled. But, even though there were no bids initially because DEEP ITM options are thinly traded, bids magically appear if the ask is slightly below intrinsic. On that point, on a VIX spike, I agree with coach that the intrinsic value causes the theory to hold.

On the other hand, I think it should be noted that 9/11 itself (which was a BIG event by most scales) only caused an initial 15-point jump. To sell when VIX was close to 60 you would've had to sit it out for about 10 days, and then sell on an intraday spike. This is contrary to the reasoning behind this type of hedge. In theory the longer you hold after the big event, the more likely it is that the VIX will drop quickly. Looking back on the actual VIX increases caused by big market drops, it would appear that the most that could be assumed for a quick exit (0-3 days after big event), would be about a 15-point jump. It seems that assuming anything bigger than that is unrealistic.

My last thought is that this hedge might work quite well in a low vol. environment like this. It could be that with VIX<15 one might be able to assume a jump slightly larger than 15-points. In any case, I don't know that a jump smaller than 15-points would provide enough profit to offset any significant loss generated from a FOTM credit spread.

 

[rallymode]

Quote from Cache Landing:



From where I stand, I've never seen a situation with options that an ITM strike with no bids couldn't still be sold if you drop your ask under intrinsic value. I have been in a couple situations where after an ER I found myself DEEP ITM and had to drop to 0.05 under intrinsic to get filled.

Hey i know what i am saying may not make much sense but i can guarantee you that the MM's will protect themselves from the easy money or arbs. I mean think about it for a sec. Say the VIX goes to 60 and the 20 calls are bid at $40, would you support that bid? Would you be willing to purchase these calls for $40 given the pending drop which is a certainty. The MM's won't support such high bids. They'd be crazy to. Now i fthe VIX is gradually bid up there thats another questions, but gradual move won't help your spreads.

On a further note, i think that comparing the vix options with index options or stock options is unrealistic because vix options do not comply with normal option pricing.


cache,
u said u never saw a real world example of where you cant get atleast intrinsic -.05 cents. Well....Here is some REAL data that somewhat goes with my arguement.

Look at the VIX ITM put options. The feb 07 20 puts are priced at 5.40/5.90. With the VIX at $11.45 that is $2.65 or 30% less than INTRINSIC. I think we will have the same situation if we get a surge in the VIX. The calls will be selling at a huge discount or the bids will stay quite low relative to the underlying. How big of a discount or how low on the bid side? I havent a clue, but i am sure it will be where there will be ZERO arb opportunity like easy bear call spreads and reversals/conversions.

now that i noticed this discrepancy, i may look deeper and see if some good calendar opportunities exist.

EDIT: you can scratch any opportunity in calendars as puts have no time value whatsoever and only intrinsic which decreases as u go further out. Now i've seen it all

 

[El OchoCinco]

Here is VXN in September 2001. VXN did not jump 15 points. It jumped 25 points, came back down and jumped up another 25 points again, not to mention the VXN move higher since SEPT 1st low of 55. If you had SEPT positions and a now long options, you had almost a 80% increase in vols on a spike. And it was before expiration in Sept.

I want to reiterate that this is for major Black Swan. Katrina was not a Black Swan or huge crash so Vols only moved close to 20 and this is not what you are hedging against. Simple adjustments will hedge against these type of moves or just getting out.

Here is the SPX move in the same time on 9-11 frame as the VXN (notice how the market dropped some 35 points or so before 9/11 causing VXN to increase, a hedge was needed even before 9/11 as the market was falling since AUG)

But a 9/11 where the market falls hard and VIX spikes is where the hedge will be a huge band-aid for ya. VIX was not before 2004 so I am using VXN here but the results would have been similar. Notice how hte market was falling hard before 9/11 so a SEPT spread would have had some protection from SEP VIX calls (if they existed) purchased in AUG.

NOW look at 2002 crash in SPX:

AND compare it to VXN in the same time period:

It is possible that hedging with VIX (if they existed at the time) woudl have helped hedge somewhat those JULY and SEPT/OCT drops.

It is looking out into the future, but the VIX options present a viable way of hedging against huge market drops that are sudden and swift which cause VIX to spike. Slow bleeds lower like post-Katrina are different and require the hedges we talk about frequently. But this gives you another choice or "option" to look into. Not saying it will work 100%, but past crash activity leads me to believe it is worth the cheap price right now of insurance with the VIX at all time lows.

Any gains in the VIX calls will offset losses in the spread, if you have to take any. With a spike those calls will have some value. Even if the $0.30 call goes to $5.30, my exmaple of 120 calls is $60,000 net profit against your spread position.

 

[Cache Landing]

Quote from rallymode:

Hey i know what i am saying may not make much sense but i can guarantee you that the MM's will protect themselves from the easy money or arbs. On a further note, i think that comparing the vix options with index options or stock options is unrealistic because vix options do not comply with normal option pricing.


cache,
u said u never saw a real world example of where you cant get atleast intrinsic -.05 cents. Well....Here is some REAL data that somewhat goes with my arguement.

Look at the VIX ITM put options. The feb 07 20 puts are priced at 5.40/5.90. With the VIX at $11.45 that is $2.65 or 30% less than INTRINSIC. I think we will have the same situation if we get a surge in the VIX. The calls will be selling at a huge discount or the bids will stay quite low relative to the underlying.

now that i noticed this discrepancy, i may look deeper and see if some good calendar opportunities exist.

EDIT: you can scratch any opportunity in calendars as puts have no time value whatsoever and only intrinsic which decreases as u go further out. Now i've seen it all

Point well taken. VIX options are a different beast. However, the APR 20 puts are priced very close to intrinsic and acting much more like equity/index options. The interesting thing is what you noted in your edit. ITM puts decrease in price as time to expiry increase. I've never seen that, but it makes sense when you think about it.

VIX is pretty much at an all time low right now. The only way for it to go lower would be for the market to stay in the current tight channel with no breakouts until FEB 07. Since VIX is based on forward pricing (the only thing that I am familiar with that is priced like this), it is possible for an option to be priced below intrinsic. The FEB 07 puts are mearly indicating the reality that in all likelyhood VIX will be above 16 at that future time. While that is not a certainty, it definitely seems much more probable, and to buy long puts right now is simply giving money away.

The calls are a completely different story. There is no ceiling for them. Thus their price increases the further we get from expiry in much the same way that equity/index options do. It could be though, that as VIX approaches all time highs, calls that are far from expiry will essentially start to decrease in price. I say decrease in the sense that ITM calls could theoretically lose intrinsic value. (I'm sure this is the point that you have been getting at.) The question being whether or not they will lose intrinsic faster than they gain it from the VIX increase.

In any case, they will still have most (>50%) of their intrinsic value, which is almost certain to be enough to make money if they were orignally bought for $0.30. But as I stated in my earlier post, I am not convinced that the jump will be big enough to justify this type of hedge. Also the further OTM the calls are when purchased, the more likely it seems that on a spike sufficient to put them DEEP ITM, they would give up intrinsic value as described above. Thus, I would have to buy them closer to ATM which would cost much more in terms of premium, and provide far less protection. The jury is still out for me.

Anyway, I think I'm done thinking about this for the night. I don't know why I allowed myself to get sucked into this.

 

[El OchoCinco]

I understand your points but a 20 call for $0.30 is cheap and the VIX is at 11.50 or so. If a huge fecal projectile hits the fan, VIX would double easily or more as noticed in the 9/11 instance or the 2002 July crash (remember the context is Black Swan drops). A 20 strike call could be adequate protection if the VIX spikes to 35 or 40 only. As I said, if the 20 Call only is worth $5.00 or $7.00 you still making major change to hedge your spreads partially. I do not think you need to go ATM if you we are talking about major caca in the spinng air mover. It is a cost you can control by how many contracts and/or strikes you choose.

Again this is a hedge against one specific type of risk, not a partial hedge we normally have been discussing.

I am not trying to convince you all to do this as the buying pressure will raise the call premiums LOL. BUt for those who were looking for Black Swan insurance, this is one possible choice. Not perfect, but presents some interesting ideas...

Quote from Cache Landing:



In any case, they will still have most (>50%) of their intrinsic value, which is almost certain to be enough to make money if they were orignally bought for $0.30. But as I stated in my earlier post, I am not convinced that the jump will be big enough to justify this type of hedge. Also the further OTM the calls are when purchased, the more likely it seems that on a spike sufficient to put them DEEP ITM, they would give up intrinsic value as described above. Thus, I would have to buy them closer to ATM which would cost much more in terms of premium, and provide far less protection. The jury is still out for me.

Anyway, I think I'm done thinking about this for the night. I don't know why I allowed myself to get sucked into this.

 

[Cache Landing]

Quote from optioncoach:

Here is VXN in September 2001. VXN did not jump 15 points. It jumped 25 points, came back down and jumped up another 25 points again, not to mention the VXN move higher since SEPT 1st low of 55. If you had SEPT positions and a now long options, you had almost a 80% increase in vols on a spike. And it was before expiration in Sept.

I was talking about VIX not VXN. It is my understanding that VIX was around during 9-11, there just wasn't options trading on it. The chart for VIX only shows a 15-point jump, then a pullback, and another 15-point jump again.

Is this not correct?