Download The Quote- Option and Stock

Trading Direction:
The Option Pit Method
Using Volatility to improve directional
trading
Option Pit
What we will cover
• Volatility Primer
• Generating buy and sell ranges for volatility
• Difference between put spreads and call
spreads
• Trading Covered calls and cash secured puts
• Using realized volatility to set up the trade
• Capital and Risk Management
• Trade Ideas
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
Historical (realized) Volatility
• How much has the stock moved over the last
time period- mean reverting
– High-Low Volatility
– Intraday Range (ATR)
– Close Close (we use)
– Open Open
• 10 day, 20 day, 30 Day
– I like 10 and 20 day because it is has noise
Realized Volatility and Mean Reversion
Implied Volatility
• This is what the market is willing to pay for
options
• Think of this as the real time supply and
demand indicator for options
• It is non-directional in nature
• IV is in flux on a daily basis
• Most platforms use IV in their pricing models
Implied Volatility and Mean Reversion
Volatility Generalizations
• We keep the “wind” of volatility to our back
whenever possible
– Let mean reversion take the position where it
wants to go
– This is important when looking for options to buy
and sell
– The direction of the underlying and direction of
volatility should fit together
Learn the Product
• IV 30- grabs the terms in IV near 30 days out
• IV60 -grabs the terms in IV near 60 days out
• IV90-grabs the terms in IV near 90 days out
– In general, the more volatility one wants to sell,
the longer the duration
Finding the Mean
Setting up positions
• When realized volatility is very high, move
farther away from the money
– Or expect to have the strike touch
• Why?
–A 1% move in the underlying price per
day is around 16% IV
–High realized volatility is a high
standard deviation- the name MOVES
Generating Buy and Sell ranges
• At Option Pit we like to keep things simple
– Buy low implied volatility (or do nothing)
– Sell high implied volatility (or do nothing)
The reason being when IV reverts we want the
position to profit in the direction of volatility gravity
Read the Vol chart
What are the Vol expectations for GDX?
• What are the buy ranges?
– 20 RV 20%
– 30 IV 25%
• What are the sell ranges?
– 20 RV 60%
– 30 IV 45%
Trading Credit spreads
• At the market- the spread is touching the ATM
strike
– More direction and some volatility exposure
• Away from the market- the spread is
approximately 1 daily standard deviation away
from the market
– More volatility and some direction exposure
• Note the difference in intent but one can lean on
the other
Trading Credit Spreads
• Using the OTM nature of the spread to help
with being “short term wrong but long term
right”
– Higher IV’s is a signal for higher returns and better
compensation for the risk of selling contracts so
move as far OTM as possible
– Have the directional bias prior to looking at the
volatility
– If no real bias in direction, think delta neutral
strategies
Setting up a trade in GDX
• Scenario for GDX
– Realized and Implied volatility is VERY high
– GDX near crash lows
– Taking GDX at lows is ok (more on this later)
• I want to get long GDX and sell the rich
premium so what is the best way?
Comparing call and put spreads
Comparing the spreads
• The put spread has a slightly higher value
equidistant from ATM
– The short put IV is higher than the call IV
– That is from skew
• In general- volatility skew creates better put
spread prices and worse call spread prices
– Call spreads tend to be cheap so you want HIGH IV
GDX skew
GDX put credit spread
Putting the factors together
• The trade is selling 10 GDX Dec 15/17 put
spreads at .33
• $333 in the full credit versus $1670 of risk is a
19.7% return to Dec
• Selling IV at recent highs
• Buys the GDX at recent lows and $1 from 2008
lows
GDX call credit spreads
Putting the factors together
• The trade is selling 10 GDX Dec 20.5/22.5 call
spreads at .26
• $260 in the full credit versus $1740 of risk is a
14.9% return to Dec
• Selling IV at recent highs
• Sells the GDX before the big drop
Looking at 1 Standard Deviation
• 1 STD to the term is 2.46
• This means that there is a good chance either the call spread
or the put spread will touch or go in the money by Dec
expiration
• If one sells out this far, there has to be a position
management strategy since the short touching is
probable.
• We will poll the group for which one we like
Cash secured puts on a swing trade
• Remember the high realized vol. with push up
the Standard Deviation
• A short term trade set at 1 Std deviation has an
implicit bet that the realized volatility should drop a
bit.
• Selling the put cash secured means you can be patient and go
for base hits
• The GDX Nov 17 puts closed .25 or 1.3% for 2 weeks
and GDX at near term lows
Setting up the GDX buy write
• Looking at a buy write the plan should always
be OWNERSHIP.
– There is no sense adding an ITM buy write if the
Investor does not want to hold the common.
– The GDX Nov 18 buy write is trading around .50 or
2.6% for 2 weeks. Finding buy writes like that
would be a nice yearly return.
Selling call and put spreads
• In general:
– We sell OTM put spreads once a name has already
moved down and we expect it to rally
– We sell OTM call spreads once a name has already
rallied and we expect it to drop or stay even
– The idea is the stock has to work to make us wrong
Managing the Credit Spread
• For short call spreads- roll once if the loss gets
to 50% of the credit
– This means the short idea is wrong for now and 1
roll is keeping the position manageable
– Once at 50% of the credit twice exit and reevaluate (at this point 1.5 STDs in one direction)
The exception is to take the short but remind
yourself to keep the risk covered since
UNDERLYINGS can rally for a long time
Managing the Put Spread
• For short put spreads- roll once if the loss gets
to 50% of the credit
– This means the long idea is wrong for now and 1
roll is keeping the position manageable
– Once at 50% of the credit twice exit and reevaluate (at this point 1.5 STDs in one direction)
The exception is to take the long if that is one’s
intent.
Managing the covered call/secured put
• Taking the equity is the goal with these positions.
– If the ATM buy write closes below the strike, sell the
next ATM strike
– If the underlying drops a lot, go farther out in time as
close to the entry position as possible.
– A 1 x 2 call spread is a possibility too
– I give myself 5% of the value of the underlying below
the strike as a stop to kill the long or buy a put
• It is easier to evaluate a position when it is not losing money,
you can always re-enter
Cash Management
• The cash secured put gives the advantage of
rolling (but be mindful of the limit)
• No more the 2-3% of assets per position
• How many puts are you short?
– It might be worth it to buy some SPY puts if there
are substantial swing and put credit spreads.
• Keep any loss within one gain and stick to it
since each strategy has some room to be
wrong built in
Trade Ideas
• Shorter Term EWZ
• Mid Term RSX
• Longer Term ARCP
• Let go through them!
Wrapping up
• Get a volatility direction with the price
direction
• Learn the IV ranges of the product
• What is the Vol. gravity direction in RV and IV?
• Gauge the level of Moneyness for spread or
buy write based on Standard Deviation
• Set the risk management routine prior to
entry
Questions?