Today I’ll tell you about a trade I often do on equities that I’m bearish on.
First, I scan for bearish chart patterns. Once I find one I look at the skew curve. I like to see a relatively flat vertical skew for at the money strikes. (Vertical skew is the skew from strike to strike in the same month). For this trade I’m not trading skew but rather direction and I’m going to take advantage of the skew that forms when my underlying moves down pushing up OTM put IV. (Skew chart below from LiveVol Pro) (Click any picture to enlarge)
As you know, when the underlying goes down the IV of the puts is driven up as the longs buy puts for protection and the speculators buy puts to speculate. As the underlying goes up, the IV is driven down when the longs sell their protective puts.
With this knowledge it makes sense to put on a trade this is long Vega to the downside and short Vega to the upside. This can be accomplished by selling a combo. Long put, short call. The plot of Vega is a beautiful sight, see below plot of Vega (Y-Axis) vs. Underlying price (X-Axis).
The only problem is you have unlimited upside risk. See below P&L chart of short combo.
So, I have identified risk to the upside. I want to hedge this trade but keep my advantageous Vega profile. I could add long calls to protect the upside but that will make me much more long vega which is not what I want to be if the underlying moves up.
We could use a bullish call vertical spread to hedge the upside some. We’re all taught that vertical spreads are vega neutral. However, the more you widen the strikes the move Vega you get because the options closer to the money have a larger vega than the farther OTM.
In my example I’m going to look at an OTM call vertical which looks like the below plot of P&L and Vega respectively:
So, by adding this call vertical I hedge some (not all ) of my upside losses and maintain my very favorable Vega structure.
Here’s the trade:
Underlying is LFC $58.55 (China Life Insurance Co Ltd) which is in a downtrend since it peaked in Dec 2009. See the two year daily chart below. (In my opinion) It has broken out of a trading range dating back to Apr to the downside. There’s a gap down to the $55 level. This is a beautiful chart example of what happens when there’s a gap, even a long time ago. Look at the lack of volume from $59 to $62 and how fast it fell through this range.
Short combo: –20 Oct $60 calls / +20 Oct $57.50 puts for debit of $0.20
Long Vertical: +10 Oct $57.50 calls, –10 Oct 62.50 calls for a debit of $2.10
The combined trade P&L looks like this:
You could modify this by buying the long call vertical with 20 contracts instead of 10 to get a better upside hedge but it also reduces downside profit a little. That looks like this:
The plot of Vega (Y-Axis) vs. Underlying price (X-Axis):
On the downside, I’m comfortable with the underlying moving up to around the $62-$63 range. At current IV and today, this equates to a loss of around $4,400 but we know that as time goes on and IV drops I will have a smaller loss. On the downside I’ll look to take some profit one spread at a time as the underlying moves down. Vega will be working in our favor and theta will be working against us. The nice thing is that Theta is not that great of a factor. You can see in the below plot of theta at 14 day intervals that theta is very small in the beginning and then gets more and more as we get closer to expiration.
I’ll post updates as this trade progresses.
*Education purpose only, not a trade recommendation!