Testing, testing, 123

Posted by: Admin: "The Vol_Trader"  //  Category: Volatility Trades

Sorry for the corny title, but I’m testing a strategy in my Thinkorswim paper-money account. I’d love some feedback and discussion of my trade logic, so please comment!

My idea is as follows:  I want to get short delta and long vega for what I think is the inevitable market crash that is coming. I’ve been saying this since the short term correction in mid July 2009, so please do not let my idea influence any of your trading decisions.  Let this be a lesson in the greeks, rather than market direction.

So, short delta and long vega, what is the first thing that comes to mind?  If you said a long put, you be correct.  The problem with naked long puts is time decay works against you.  You can only be right if the market moves down and does so right away.  If it goes down slowly you lose.  If it stays the same you lose.  If it goes up you definitely lose quickly, not only from delta but also from Vega as IV generally goes down with market rallies. 

I want to get long vega and short delta by purchasing puts.  I chose to buy OTM Jun 115 puts for $1.55 with SPY trading at $120.16, 50 contracts.  (The simple facts: These are .25 delta, so they have a close to 25% chance of expiring $0.01 ITM which of course means I lose the full $1.55.  In order to break even I need them to be $1.55 ITM or SPY at $113.45.  Any lower than that is profit.)

This is what the naked long Jun $115 put looks like at May Expiration below in the Thinkorswim analyze tab. (Not Jun Expiration, I’m going to add May options to this trade and the plan is to be out by May expiration.) At May expiration and at the current price and IV the max loss is around $7,700, and breakeven is around $117.

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In order to offset theta, I decided to sell a Jun ATM 120 Straddle 25 times. Adding the straddle actually makes the theta slightly positive (close to zero) at the current price. The naked long put has a negative theta of around $150 / day.  Now, combined long put, short twice as many straddles leaves me with risk to the upside because I’m short naked calls from the straddle.  The short puts from the straddle ore more than hedged due to twice as many long puts.  The comparison of the two trades are below.

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You can see the naked put does better if the market falls below $115 but the combined trade does better up to around $125 but this chart is not showing something, the effect of vega. 

Below is a chart of Vega on the Y axis and underlying price on the X axis.  The combined position clearly has an advantage to the upside.  It is short vega above $117.50 whereas the long put is always long vega.  Remember, as the market goes up IV generally goes down. 

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The last adjustment is to address the upside risk.  I’m net short 25 June calls.  To offset this I will buy 25 May OTM $123 calls for $0.68. Call these the cost of insurance.

Now, I have less risk to the upside than just the naked long put.  In the below chart you can see the combined position has a max loss at current IV of around $4,400. I sacrifice downside profit, but I significantly reduce risk.  Plus, If the market crashes I will be long Vega and should do really well to the downside.

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Below is a year to date chart of SPY on the top and 30 IV on the bottom from LiveVol Pro.  You can see IV is at a low of 13.81% right now.  If we have a major pull back to where we were on 2/5/2010 you can assume IV will be at least the same, but probably much higher than 23.77% that it was then.  this 10% increase translates to $1,200 profit on the combined position with Vega currently at $120. Remember from the chart of Vega, Vega increases as SPY drops too, so the profit from Vega should be much higher.

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After all this, I’m considering putting this position on in real money tomorrow in a much smaller quantity…

Remember, nothing on Voltraderblog is a trade recommendation but just an educational forum…

Bonus: Why does IV go up as the market go down and IV go down as the market goes up?  — When the market goes down longs buy puts for protection.  Remember option pricing is controlled by supply and demand. Demand goes up and the market makers having to take on more risk being short options increase prices of puts.  The only variable that is unknown in option pricing formulas is IV, therefore, as option price goes up, IV has to go up as well working backwards from option pricing formulas.