Boot Camp Part 2

Volatility, Directional Trading, And Spreading

Option Pit
 Option Pit Boot Camp 1 Quiz

 
•What is the flow of model inputs to generate P/L?
  inputs- position change- greeks – p/l
•Is acceleration a fair way to describe gamma and what is the market
factor most closely associated with it?
•Yes it is and the factor is realized volatility
 
•What is positive Theta? Is it free?
•Time decay that accrues as dollars and it is not free since there is risk
to get it
 
•What is Vega in a position? Please explain.
•Sensitivity to a change in FORWARD VOL. but we use IV
 You Will Learn
• What is Low Vol
• What is High Vol
• How to Trade vol and direction
• The Risk Reversal and Sling-Shot
• Call and Put Spreads
• The basic butterfly directional trade
What is Low IV
 What is Low IV
• There is always some nuance to guessing low vs
high
• It takes studying where the reversion levels are
– And how far below mean and close to extremes
current IV is
– How low IV is relative to VIX, VXN, and RVX
• How has the underlying been moving, relative to
vol
• Has the underlying had MOMENTUM, so ‘HV’ is
low but movement his high
Low/High IV
What is High IV
 High IV
• Like low IV high IV is a bit of art and science
• Where has high been in the stock historically
• Where is the VIX
• Is the underlying moving, will it continue to
move
– Relative to the movement how much ‘slack’ is
there in an IV drop
IV
 Skew
• Because of supply and demand, and the
lognormal assumptions, volatility does not
have a flat distribution:
• Options do not move uniformly
across the curve
Skew
Steeper and Flatter
 What is Steep/Flat Skew
• When upside calls are priced at a higher IV,
and have a real value relative to ATM, skew is
flat
• When downside puts are trading at a higher
than normal IV relative to ATM skew is steep
• steep is just the opposite, when upside gets
smashed.
• When downside gets really flat, to the point it
is about even with ATM, it should be bought
Setting up a position to reduce risk

Spreads of every flavor!

 Long Calls
• Calls should be bought when IV is at extremely
low levels
• The lower the vol the softer the deltas that
should be bought (to a point)
– Buy ATM when IV is low, but might go lower on a
rally
– Buy slightly OTM when vol gets disgustingly cheap
 Long Calls
• Look for trades where the underlying has been
moving but the IV is cheap in comparison
• Look for MOMENTUM (like I discussed above)
• It is easy to make money owning calls if one is
willing to wait
• Look to make 25-50% on calls
• Hope for a GAP up higher for homeruns, don’t
got looking to hit it out of the park
 Long Puts
• It is easier to buy ATM puts than ATM calls
– Because IV rallies on a sell off….usually
• Put should be bought when IV is at low levels
• The lower the vol the softer the deltas that
should be bought (to a point)
– If IV is low but there is some curvature it can make
sense to still buy ATM
– Skew is much more important in vol selection of
long puts
 Short Puts and Calls
• When it comes to vol, selling naked calls is an
extremely risky bet with serious margin blow
up potential
• Since upside calls get cheaper, it usually
makes sense to only sell covered calls or call
spreads
 Puts
• Sell puts in stock one wants to own, the
steeper the skew, the higher the vol, the
lower the strike
• As we stated, look for yield
 Directional Spreading
• What about when doesn’t want to buy OR sell
an option, what if one is uncertain about IV
movement
• What if one doesn’t want to spend a lot of $$$
• This is when the time comes to spread
• Traders spread for two main reasons:
• Because they do not want to take a vol position
• Because they want to lower the cost of the trade and
can get the right yield
 Credit vs Debit
• There are many traders that prefer ‘credit
spreads’ to ‘debit spreads’
• Especially in stocks that don’t pay a dividend
there is almost no difference between credit
and debit spreads
• In fact, in the money debit spread sometimes
have a better pay out than OTM credit spread
 Credit to Debit
• If a trader sells an AAPL Sep20 90/95 Put
Spread at 1.50 there is a direct relationship to
where the 90/95 call spread should be trading
(because of synthetics so look for them)
• Take the Width of the spread minus the credit
received to calculate the debit spread
Example
 The Army of Ants
• It is estimated that the weight of all the ants in
the world equals or exceed the weight of all
humans
• This is what retail traders can do in stocks
when they sit there and blast ‘credit spreads’
• Always take the time to look at the ITM debit
• They can TRADE for as cheap at a full .10
cheaper on a 5 point vertical, worse on a 10 or
15 pointer
 In Reality
• While it doesn’t matter whether one is trading
a credit or debit spread, based on trade
structure one is still making a decision on
buying or selling premium
– When the short option is closer to ATM the trade is a
premium sale
– When the long option is closer to ATM the trade is a
premium buy
– When it splits the difference it is likely close to premium
neutral
 When to buy
• Much like a straight buy or sell, buy premium
when one expect the stock to move
• Buy a spread when the risk reward is favorable
– If I can get a call spread where the pay out odds
are better than the chances of success I am in
• This will happen when SKEW is in your favor
– That means that MOVEMENT is bid over the
straddle
 Using Skews
• A classic time to buy a spread
– NFLX
– Curve
Is bid
 Credit Spreads
• Sell for the same reason that one would sell a
put
• IV is normal or elevated
• Stock unlikely to drop
• Looking to pick up income
• Flatter skew is actually better
– Believe it or now skew typically flattens in higher
IV situations on the downside
 Credit Spread
• The big difference between puts and put
spreads or call spreads is that the trader is
looking for income, not ownership/selling a
security
 Risk Reward
• Credit Spread:
– Get the right risk reward relative to odds
– If the odds of breaking even are 65% you better
collect close 35% of the premium
– Flat skew
• Debit Spreads
– Good risk reward (same as above)
 Closing
• Shoot for 60% the credit or better
• Do not shoot for more than 75%
• Close if the credit increases by more the 40-
50%
– Or adjust with a fly
• If one option is worth .05, you might have to
just buy the short back
 Adjusting Spreads
• If the underlying moves against you, have 1 of
two options prepared
• Have a max loss and kill it
• Turn it into a directional butterfly
• I am not a fan of rolling down and increasing
size (that is how people blow out)
– It is okay to roll down and leave same size on in an
attempt to break even
 Directional Spread Checklist
• What Is my view of the market
• What is my view of this stock
• What is my view of the volatility of the options
• What is the best spread for that view
• What is the best strikes for that spread
• What is my profit target/max loss
• Do I have an adjustment
 Advanced Spreads
• By truly trading a direction AND volatility
traders can be wrong and still win
• Reg-T spreads that use IV AND direction
– Modified Risk Reversal
– Slingshot Collar
– Butterflies
 Modified Risk Reversal
• What if one thinks the stock is going higher,
but hates paying for stuff
• What if one hates the idea of owning a stock
• Sell a put spread OTM
• Buy a call spread, or calls on a ratio
• Collect a net credit
Standard Risk Reversal
RR
Modified Risk Reversal
Risk Charts: Mod RR
 Risk Reversal
• Use a risk reversal when one wants to take
delivery
– More income
– More risk
• Use a Modified risk reversal when you think a
stock is going higher
• Don’t want to pay for calls
• Won’t own the stock
 Slingshot Collar
• Named by Charles Cottle
• Trade allows stock holder to ‘collar a position’
but still have upside on the trade
– Trader Buys the Stock
– Buys a protective put
– Sells a call spread instead of a simple call
– Call Spread can be ratio’d to produce a positive
theta spread
• Comes with a cost
 Sling Shot

Standard

Ratio
 Butterfly
• The Directional butterfly is the perfect spread
for a slow moving trade.
• Allows trader to ‘shoot for a target’
• Is SUPER cheap if set up properly
• Great for the ‘slow play’
• Allows for almost NO volatility exposure
 Example TSLA
• I think that TSLA is going to be trading
between 270-275 by September expiration
• The IV is not high, but I think its going to drop
• I want to get paid if the stock creeps higher
Example
 Tips
• This is good when IV is high and one wants to
be a bull
• Its also good when one has a good feel on
movement
• Set the 1st long wing at your target price (270)
because the stock is going to overshoot
• You are not trying to collect all the premium
– If you can return 100% that is a huge win
 Summary
• We have even more coming
• Volatility is the key to all trades in options
• Credit and Debit spreads are the same
• Risk reversals and modified reversal serve
different purposes
• Flies are cool
 Boot Camp Quiz 2
• Explain what realized volatility is?
• What does low IV mean?
• What is the chief advantage of a spread?
• Is there a low IV type of trade?
 Thanks!
For question you can contact:

mark@optionpit.com
andrew@optionpit.com
1(888) Trade-01