Boot Camp Part 2

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Boot Camp Part 2

• Volatility, Directional Trading, And Spreading

Option Pit
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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
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• 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

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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

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What is Low IV
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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

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Low/High IV
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What is High IV
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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

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IV
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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

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Skew
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Steeper and Flatter
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What is Steep/Flat Skew

• When upside calls are priced at a higher IV, and
  have a real value relative to ATM, skew is steep
• When downside puts are trading at a higher than
  normal IV relative to ATM skew is steep
• Flat is just the opposite, when upside or
  downside gets smashed.
• When downside gets really flat, to the point it
  is about even with ATM, it should be bought

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Setting up a position to reduce risk

• Spreads of every flavor!

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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

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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, dont got
  looking to hit it out of the park

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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

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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

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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

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Directional Spreading

• What about when doesnt want to buy OR sell an
  option, what if one is uncertain about IV
  movement
• What if one doesnt 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

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Credit vs Debit

• There are many traders that prefer credit
  spreads to debit spreads
• Especially in stocks that dont 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

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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 HA I TOLD YOU)
• Take the Width of the spread minus the credit
  received to calculate the debit spread

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Example
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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

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In Reality

• While it doesnt 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

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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

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Using Skews

• A classic time to buy a spread
• NFLX
• Curve
• Is bid

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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

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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

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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)

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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

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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

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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

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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

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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

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Standard Risk Reversal
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RR
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Modified Risk Reversal
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Risk Charts Mod RR
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Use

• 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
• Dont want to pay for calls
• Wont own the stock

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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 ratiod to produce a positive
  theta spread
• Comes with a cost

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Sling Shot
Standard
Ratio
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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

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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

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Example
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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

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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

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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?

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Thanks!

• For question you can contact
• mark_at_optionpit.com
• andrew_at_optionpit.com
• 1(888) Trade-01