Option Pit

Volatility:The Option Pit MethodUsing Volatility to Trade Direction

Single Options, Spreads, Fly’s

What You Will Learn

• Value of Mean Reversion• buy/sell option decisions• What are hard and soft deltas• Trading Credit and Debit spreads• Trading Directional Butterflies and Broken

wing flies

Implied Volatility

• Q: What makes trading volatility different than trading a stock?

• A: Over the long term we know where implied volatility of a stock or index is going to go. We do not know where the stock price is going to go– IV mean reverts

AAPL Stock

Is there a Mean?

No: look at the 50 and 200 DMA

AAPL IVIs there a mean?

Yes!!!!

Mean Reversion

• A stock price can go anywhere and stay there• While volatility can GO anywhere, it cannot

stay anywhere• It must revert to its mean overtime• Understanding this can help with buy and sell

decisions

Getting Long

• When one wants to go long one can– Sell puts– Buy calls

• Despite what you have been told, there are perfectly acceptable times to do both

Short Puts

• A short put is Long Delta and Short Vega– Thus the trader is hoping the stock moves higher,

and the IV comes in

• What makes IV drop?

Short Puts

• IV often drops, because HV drops• Thus a short put is actually a play on lower

realized volatility• When selling a put, the trader is really betting

that the underlying WON’T GO DOWN

GLD

Long Calls

• A long call is long delta and long vega– The trader is hoping that IV goes up and vol goes

up– What makes that happen?

Long Call

• We are actually hoping that the stock is going to go up, not simply creep higher

• We want upward movement and an uptick in realized volatility

• We are betting the stock is GOING TO GO UP

AAPL

Getting Short

• Like going long, when one is making buy/sell option decisions, one must take IV into account

• When IV is high and one thinks the stock is going to go down: sell calls

• When IV is low and one thinks the stock is going to fall: buy puts

Short Calls: AAPL

Buying Put: IBM

What Is Delta

• Delta has several definitions. However, the one most commonly used is the correlation of an option to its underlying.

• Thus an options with a positive .60 delta will make .60 for every dollar the underlying rallies

• It will lose .60 for every dollar the underlying falls

Deltas

• Hard Deltas– A hard delta is relatively resistant to a change in

volatility

• Soft Deltas– A soft delta is relatively sensitive to a change in

volatility

• Understanding the difference can help with strike selection

Hard Deltas

• When would one want hard deltas?– When one isn’t sure of IV future movement– When IV is very high– When one isn’t sure of the severity of the

expected move but wants to have limited risk

AAPL

AAPL

Dec 5

Dec 6

The Math• 12/5

– Buy 1 AAPL Dec 565 put for 10.50• Total Outlay: $1050• Total Delta: -43

• 12/6– Sell 1 AAPL Dec 565 put at 13.50

• Cash Received: 1350• Profit: 300.00

• 12/5– Buy 3 AAPL Dec 545 puts for 3.80

• Total Outlay: $1140• Total Delta: -75

• 12/6– Sell 3 AAPL Dec 545 puts at 4.90

• Cash Received: 1470• Profit: 340.00

Keys to Hard Delta• Hard delta is a time that the trader wants to

take vol out of the equation• Trader is under the assumption that vol is

going to drop• Make sure to recognize when one is taking on

TOO much delta• Make sure to do the math on how much delta

one is getting for the cost, and how that will change when IV drops

Soft Deltas

• As soft deltas are more sensitive to IV changes, and there are some very specific times where they can make a lot of sense– IV is really low– We are expecting a major move– We want to make a cheap bet

PNRA

PNRA• 11/19

• 11/22

The Math• 11/19

– Buy 1 PNRA Dec 165 call for 9.00• Total Outlay: $900.00• Total Delta: 75

• 11/23– Sell 1 PNRA 165 call at 15.00

• Cash Received: 1500• Profit: 600.00

• 11/19– Buy 3 PNRA Dec 175 calls for 2.85

• Total Outlay: $855.00• Total Delta: 120

• 11/23– Sell 3 PNRA Dec 175 calls at 6.40

• Cash Received: 1920.00• Profit: 1065.00

Soft Delta

• The key to a good soft delta trade is to believe that IV wont drop on a move.

• If one is relatively certain IV will remain stable then cheap options and cheap deltas will out perform in the money or even ATM options

• Obviously be wary of going ‘too soft’

XYZ• Q: XYZ stock is at a near all time low in IV

terms, at the same time the stock is peaking out and realized Vol is increasing

• The Trader wants to get short delta in what order would the trader choose to get short1. Sell An ITM Call that has a 75 delta2. Sell an 3 OTM Calls that are each 25 delta3. Buy 1 ITM put that is 75 delta4. Buy 3 OTM Puts that are each 25 delta

Directional Spreading

• In the above scenario, believe it or not there are times where none of the answers are truly the best answer

• 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 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 spreads– EXAMPL AAPL DEC 560/550

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– AAPL– Curve

Is bid

AAPL Call Spread• AAPL closed just above 560

• Odds are about 3 to 1 on something that has 50/50 odds of ending up in the money

Sell a Spread

• Again, like selling a straight option the best time to get short premium is when one expect the underlying NOT to move in a direction

• If IV is elevated but COULD go higher• Try to get SKEW in your favor– This will increase risk reward

• Get risk reward as favorable as possible

Risk Reward

• Unlike a debit spread risk reward will likely NOT be 50/50 on its surface

• But, unlike a debit spread one does not need movement to happen

• ONE wants movement NOT to happen• Using SKEW can help maximize return– For a PUT SPREAD: a tighter spread with more

contracts will outperform WIDER and FEWER contract

GOOG

GOOG

• 5 pointer

• 10 Pointer

Target

• In general always try to make more than you are losing

• Shoot for 50% of premium collected• Try to hold losses to 30% of premium collect• Take never lose more than 50% of premium

Directional Butterflies

• Directional butterflies are an extremely inexpensive way to trade on direction

• They are great for expensive names• ‘momo’ plays– In using butterflies trader tries to pick where

momentum will end

• Low risk high reward trades

Mistakes

• Putting on the fly is easy, choosing when to take it off is the key

• Many traders get ‘greedy’ with directional flies because they see how much premium can be made if the underlying ‘parks’

• Because of the risk/reward I am usually happy with 20% after commission

Keys to Success

• Execute when IV is elevated• When SKEW in the direction of the trade is

‘flat’• Target should be about 1 week• Set the wing closest to the underlying price at

the level the trader expects the stock to hit– NOT THE THORAX– Will prevent ‘over shooting’– You will be surprised how well the fly does at the wing

Notice P&L at Wing

Broken Wing Butterflies

• Broken wing butterflies are a retail trader’s way of trading a ‘front spread’

• At onset delta will be opposite of the direction the trader wants the underlying to move

• As time passes trade pick up a lot of delta– Trader expect IV to be stable and fall– Trader is trying to trade skew and volatility– One wants traders to see skew fall and vol fall

Keys to Success

• Try to get a credit on the spread• Set a time frame of 10 days or so• Set the long at the target price– Will avoid overshooting

• SKEW SKEW SKEW– Well structured a BWB will win regardless of the

movement in the stock

AAPL

• On ‘track the trade’ I walked through an AAPL butterfly

• SKEW was ‘JACKED UP’ as traders were running IV and SKEW up: Thursday Morning

Today

• AAPL moved in the opposite direction of my spread

• But IV and SKEW moved in my favor• Now I am up 100.00 on 3 spreads!

Summary

• Belief in mean reversion is key• When IV is high, we sell it, use harder deltas• When IV is low, we buy it, use softer deltas• Spreads are just like naked options• Butterfly trades are for cheap bets• Vol and Skew is the key to successful

spreading

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