"WELCOME THOSE BIG, STICKY, COMPLICATED PROBLEMS... IN THEM ARE YOUR MOST POWERFUL OPPORTUNITIES..."
Watergate was the biggest political scandal in this country's history but it didn't start out that way. Rather, it started as an overlooked story about a bungled break-in... many thought it was nothing more than a prank. For two young unknown reporters, however, something didn't make sense and they started asking questions.
Back in July - in anticipation of rising market volatility - I wrote a post on buying volatility to hedge against systematic corrections...
http://tancockstradingblog.blogspot.com/2015/07/buying-volatility-to-hedge-against.html
One thing I noticed in researching that post was that it was difficult to get significant protection using long-dated index options. I noted the issue but moved on with the problem I was trying to solve at the time.
Then in August, I wrote about a new trading model I built that was ultimately called 'Optimized Positive Convexity'...
http://tancockstradingblog.blogspot.com/2015/08/optimizing-equity-returns-using.html
When building the model, I originally thought that the volatility calculations were wrong because when I compared long-dated implied volatility on SPY options to the projected volatility the measurements were significantly different. However, when I ran the same comparison on individual stocks the numbers were much closer. Again, I noted the observation but continued with the problem at hand.
Now, I've decided to revisit the issue.
The implied volatility on the SPY December at-the-money put option is currently 15.1% versus a projected volatility of 8.1%... almost double! Using our equity price simulator (which projects an expected return of -4.9% during the period) we can visualize the difference between these two assumptions:
December SPY Projected Distribution:
December SPY Implied Distribution:
For comparison, the 9 day implied volatility on the SPY is 10.5% versus a projected volatility of 8.9%... significantly closer. The VIX is currently at 16.17... close to pre-selloff levels, so I dismiss the notion that the difference is attributable to recent market volatility.
WHY DOES THIS DISPARITY EXIST?... AND WHY IT DOESN'T MATTER...
A quick Google search yields a lot of complex theories as to why this difference exits. Ultimately, I have dismissed most of them in favor of a simple explanation... the volatility is high because the SPY is widely used as a hedging tool and the price of the options are simply bid up on demand. For our purposes, however, the reasons why are not really important... if we're confident that the difference is both real and material we, as traders, should try to find a way to capitalize on an opportunity.
There are a couple of different approaches we can take but they both involve selling long-dated volatility.
First, we can take a directional approach. If we believe the projected period return of -4.9%, the best approach would be to sell in-the-money call options. By setting up a bear call spread, we can sell the December 190 call for $13.63 and buy the 208 call for $1.91. The trade has a break-even price of approximately $202.34 and has a max payout of 1.87x our max loss.
Here's the payoff chart:
Secondly, we can take a more agnostic approach and take maximum advantage of extrinsic option premium by selling the at-the-money call. Again, using a bear call spread, we sell the December 201 call for $5.49 and buy the 208 call for $1.91. The break-even price is now approximately $204.75 and the max payout is roughly equal to the max loss.
Here's the payoff chart:
Great opportunities seldom present themselves clearly. For Bob Woodward and Carl Bernstein, their greatest opportunity started out as a mundane assignment that no one else wanted... 40 years later, their names are synonymous with investigative reporting because they explored complex problems that just didn't make sense.
Watergate was the biggest political scandal in this country's history but it didn't start out that way. Rather, it started as an overlooked story about a bungled break-in... many thought it was nothing more than a prank. For two young unknown reporters, however, something didn't make sense and they started asking questions.
Back in July - in anticipation of rising market volatility - I wrote a post on buying volatility to hedge against systematic corrections...
http://tancockstradingblog.blogspot.com/2015/07/buying-volatility-to-hedge-against.html
One thing I noticed in researching that post was that it was difficult to get significant protection using long-dated index options. I noted the issue but moved on with the problem I was trying to solve at the time.
Then in August, I wrote about a new trading model I built that was ultimately called 'Optimized Positive Convexity'...
http://tancockstradingblog.blogspot.com/2015/08/optimizing-equity-returns-using.html
When building the model, I originally thought that the volatility calculations were wrong because when I compared long-dated implied volatility on SPY options to the projected volatility the measurements were significantly different. However, when I ran the same comparison on individual stocks the numbers were much closer. Again, I noted the observation but continued with the problem at hand.
Now, I've decided to revisit the issue.
The implied volatility on the SPY December at-the-money put option is currently 15.1% versus a projected volatility of 8.1%... almost double! Using our equity price simulator (which projects an expected return of -4.9% during the period) we can visualize the difference between these two assumptions:
December SPY Projected Distribution:
December SPY Implied Distribution:
For comparison, the 9 day implied volatility on the SPY is 10.5% versus a projected volatility of 8.9%... significantly closer. The VIX is currently at 16.17... close to pre-selloff levels, so I dismiss the notion that the difference is attributable to recent market volatility.
WHY DOES THIS DISPARITY EXIST?... AND WHY IT DOESN'T MATTER...
A quick Google search yields a lot of complex theories as to why this difference exits. Ultimately, I have dismissed most of them in favor of a simple explanation... the volatility is high because the SPY is widely used as a hedging tool and the price of the options are simply bid up on demand. For our purposes, however, the reasons why are not really important... if we're confident that the difference is both real and material we, as traders, should try to find a way to capitalize on an opportunity.
There are a couple of different approaches we can take but they both involve selling long-dated volatility.
First, we can take a directional approach. If we believe the projected period return of -4.9%, the best approach would be to sell in-the-money call options. By setting up a bear call spread, we can sell the December 190 call for $13.63 and buy the 208 call for $1.91. The trade has a break-even price of approximately $202.34 and has a max payout of 1.87x our max loss.
Here's the payoff chart:
Secondly, we can take a more agnostic approach and take maximum advantage of extrinsic option premium by selling the at-the-money call. Again, using a bear call spread, we sell the December 201 call for $5.49 and buy the 208 call for $1.91. The break-even price is now approximately $204.75 and the max payout is roughly equal to the max loss.
Here's the payoff chart:
Great opportunities seldom present themselves clearly. For Bob Woodward and Carl Bernstein, their greatest opportunity started out as a mundane assignment that no one else wanted... 40 years later, their names are synonymous with investigative reporting because they explored complex problems that just didn't make sense.
Comments
Post a Comment