IT'S DEJA-VU ALL OVER AGAIN...
-Yogi Berra
After writing the piece on hedging theta, I realized that there is more that can be - and more importantly should be - covered. So here comes part two... hopefully, it's better than most sequels.
First, here's a link to the original...
http://tancockstradingblog.blogspot.com/2015/08/hedging-theta-decay.html
Anytime you are long an option you are also long volatility; regardless of whether it's a call or a put. As I've written before, being long volatility automatically makes you short theta... or you could even say that you're short time as the value of the option has an inverse relationship to time... but let's not get too philosophical.
In the previous piece, I wrote about one strategy that can be used to hedge short-term theta decay... the vertical bull-put or bear-call spread. However, especially in relation to the optimized positive convexity strategy, there is another strategy worth exploring... the butterfly spread.
The butterfly spread is an options strategy that shorts two options at one strike price while going long two individual options on either side of that strike to limit risk. The point is to capture option premium directly at - or very near to - the short strike.
Here's what the payoff structure of a typical butterfly spread looks like:
This butterfly spread is on SPY put options that expire in 8 market days, the SPY was trading at $210 at the time. The trade is made up of the following positions:
First, since the short strike is above the current market price of the underlying asset, the trade has a directional bias and is acting as a hedge against a positive convexity portfolio that is net short. Sound familiar? The two current positive convexity trades that I've detailed (QIHU and SWKS) are both shorts. This will be balanced out in the near future but for now that's where we're at.
Second, the payoff is 2:1 but again, only if SPY closes directly at $212 on the expiration date. This actually works well for us, however, because the positive convexity payout structure (in a short trade) has area of maximum loss is typically at and just above the initial price of underlying asset... so modest market moves to the upside are the most damaging. Large moves to the upside are protected by the equity overlay.
See the second chart on the 'Using Options to Drive Returns' post to refresh your memory of the payout structure on an optimized positive convexity position...
http://tancockstradingblog.blogspot.com/2015/08/follow-up-on-qihu-short-trade.html
THE FUTURE AIN'T WHAT IS USED TO BE
-Yogi Berra
I'm a Yankee fan so I give myself free reign to use as many Yogi Berra and Casey Stengel quotes in one post as I like.
The butterfly spread can be utilized in another way when looking to counter the impact of theta decay on a long volatility portfolio. Given the current market environment, which is almost entirely devoid of volatility, there is an interesting relationship between implied and projected volatility.
See the post on projecting equity prices to refresh your memory of how volatility expectations are factored into options trades...
http://tancockstradingblog.blogspot.com/2015/08/projecting-equity-prices-using.html
Here's a chart that shows the projected price dispersion for the 22 day SPY (the September options expiration date)...
...note the majority of the upside projected price dispersion falls between $210 and $217.
For comparison, here's the implied price distribution for the 22 day SPY...
...here, the majority of the upside implied price dispersion falls between $210 and $220.
The lack of a y-axis distorts the difference between these two charts but it's still pretty clear to see that implied future volatility is - and has been for a while - greater than projected and realized volatility for the SPY.
This is great news for a long volatility portfolio.
I've said before that I'm not a big fan of over hedging a portfolio because there is a cost incurred that has to be overcome by the original investment. However, if the dispersion in volatility creates a real opportunity for our long volatility portfolio and here's how I would try to arbitrage the difference...
Going back to our butterfly spread - and remembering that our portfolio is currently net short - I would set up the following trade:
By trading the implied volatility, the configuration covers the majority of the upside projected volatility between $210 and $216 over the life of the underlying options. Also, if we got a little close to the expiration or used a closer expiration date, we would get a better risk/reward payout than 3:2.
Ultimately, the decision to hedge, hold or fold boils down to your own risk tolerance. I would hold my positions and if they were mostly unchanged within 7 days of expiration, then I would decide whether to hedge or exit.
-Yogi Berra
After writing the piece on hedging theta, I realized that there is more that can be - and more importantly should be - covered. So here comes part two... hopefully, it's better than most sequels.
First, here's a link to the original...
http://tancockstradingblog.blogspot.com/2015/08/hedging-theta-decay.html
Anytime you are long an option you are also long volatility; regardless of whether it's a call or a put. As I've written before, being long volatility automatically makes you short theta... or you could even say that you're short time as the value of the option has an inverse relationship to time... but let's not get too philosophical.
In the previous piece, I wrote about one strategy that can be used to hedge short-term theta decay... the vertical bull-put or bear-call spread. However, especially in relation to the optimized positive convexity strategy, there is another strategy worth exploring... the butterfly spread.
The butterfly spread is an options strategy that shorts two options at one strike price while going long two individual options on either side of that strike to limit risk. The point is to capture option premium directly at - or very near to - the short strike.
Here's what the payoff structure of a typical butterfly spread looks like:
This butterfly spread is on SPY put options that expire in 8 market days, the SPY was trading at $210 at the time. The trade is made up of the following positions:
- Short 2 $212 puts at $2.43
- Long 1 $210 put at $1.45
- Long 1 $214 put at $4.07
First, since the short strike is above the current market price of the underlying asset, the trade has a directional bias and is acting as a hedge against a positive convexity portfolio that is net short. Sound familiar? The two current positive convexity trades that I've detailed (QIHU and SWKS) are both shorts. This will be balanced out in the near future but for now that's where we're at.
Second, the payoff is 2:1 but again, only if SPY closes directly at $212 on the expiration date. This actually works well for us, however, because the positive convexity payout structure (in a short trade) has area of maximum loss is typically at and just above the initial price of underlying asset... so modest market moves to the upside are the most damaging. Large moves to the upside are protected by the equity overlay.
See the second chart on the 'Using Options to Drive Returns' post to refresh your memory of the payout structure on an optimized positive convexity position...
http://tancockstradingblog.blogspot.com/2015/08/follow-up-on-qihu-short-trade.html
THE FUTURE AIN'T WHAT IS USED TO BE
-Yogi Berra
I'm a Yankee fan so I give myself free reign to use as many Yogi Berra and Casey Stengel quotes in one post as I like.
The butterfly spread can be utilized in another way when looking to counter the impact of theta decay on a long volatility portfolio. Given the current market environment, which is almost entirely devoid of volatility, there is an interesting relationship between implied and projected volatility.
See the post on projecting equity prices to refresh your memory of how volatility expectations are factored into options trades...
http://tancockstradingblog.blogspot.com/2015/08/projecting-equity-prices-using.html
Here's a chart that shows the projected price dispersion for the 22 day SPY (the September options expiration date)...
...note the majority of the upside projected price dispersion falls between $210 and $217.
For comparison, here's the implied price distribution for the 22 day SPY...
...here, the majority of the upside implied price dispersion falls between $210 and $220.
The lack of a y-axis distorts the difference between these two charts but it's still pretty clear to see that implied future volatility is - and has been for a while - greater than projected and realized volatility for the SPY.
This is great news for a long volatility portfolio.
I've said before that I'm not a big fan of over hedging a portfolio because there is a cost incurred that has to be overcome by the original investment. However, if the dispersion in volatility creates a real opportunity for our long volatility portfolio and here's how I would try to arbitrage the difference...
Going back to our butterfly spread - and remembering that our portfolio is currently net short - I would set up the following trade:
- Short 2 September $213 puts at $4.97
- Long 1 September $208 put at $2.75
- Long 1 September $218 put at $9.26
By trading the implied volatility, the configuration covers the majority of the upside projected volatility between $210 and $216 over the life of the underlying options. Also, if we got a little close to the expiration or used a closer expiration date, we would get a better risk/reward payout than 3:2.
Ultimately, the decision to hedge, hold or fold boils down to your own risk tolerance. I would hold my positions and if they were mostly unchanged within 7 days of expiration, then I would decide whether to hedge or exit.
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