Spy and Sds pairs trade

[Davidkot81 11]

A trade idea:

 

trade ditm call credit spreads for both SPY and SDS

 

eg:

Current price of SPY: 216.41

call credit spread sep 16 options (60 d to expiration)

sell 200 -1 (86 delta)

buy 207 +1 (76 delta)

$617 credit, max gain $629, max loss $79

 

current price of SDS: 16.67

call credit spread sep 16 options (60 dte)

sell 15 -2 (89 delta)

buy 16 +2 (71 delta)

$139 credit, max gain $152, max loss $48

 

what do you think?  Paper trading looks promising.

 

 

 

[Amos 4]

Are you looking for a certain IV or any other variables to consider selling options for the premium? The reason I ask is when IV is low options are cheap and when high they are expensive.

[Rogers 263]

In general this is not a good environment for selling premium.  

[Yowster 8,092]

Since you are selling ITM credit spreads, this trade is basically synonymous with buying the corresponding OTM put debit spreads using the same strikes.   When I think of "selling premium" that is usually based on OTM/ATM  strikes.   So, since both SPY and SDS are tied to S&P500, this is basically a RIC looking for a larger move in the S&P - with the exception being that you have more of a potential gain on the S&P500 dropping compared to rising above your strikes.

[Davidkot81 11]

A couple of things--

So the IV percentile in SDS is pretty good- on the order of 50.  For SPY it can't go lower (0) which is bad.

However the losses in spy are pretty low if it goes against you ($79 loss vs $629 gain).  For sds the losses were $48 vs a gain of $152 max.

Another good thing about the the trade is that it takes advantage of volatility skew.  So for sds, you sell the $15 call which has an implied volatility of 83% while you buy the $16 call which has an i.v. of 24%.  Similarly you also take advantage of volatility skew in SPY when you sell the ditm credit spread there.  (40% vs 20%)

one thing I did not do was make sure the delta of spy is twice that of sds.  Important because if there is a moderate drop in the spy the money gained might not offset the losses in sds (since it is a double leveraged instrument). 

Today sds really was a winner - this may be because time value was taken out to a large degree even though the spy just inched slightly upward.

 

In response to Yowster- I believe if you see no movement or any market gain that will be profitable.  Volatility should decrease with time as well so the skew should decrease near expiration I believe.  So both time and volatility value can be pocketed. If the market moderately drops that could be bad if the gains in spy are offset by larger losses in sds (unless the spreads are delta adjusted which may not be easy).   However if the losses are larger the gains in spy will overcome the max loss in sds.

Edited July 20, 2016 by Davidkot81

[Yowster 8,092]

@Davidkot81- A couple of thoughts, as there are basically 2 ways to look at profits (and losses) from this trade:

1. Profit by the SPY or SDS moving significantly toward/beyond your strikes, thereby making the credit spread lessen in value and increase your gain.  My reply was based on this.
2. Your comments indicate you are also thinking about IV changes potentially helping your trade.  The problem I see with that in this case is that you are using DITM options so most of the spread value is intrinsic - for the 207/200 SPY vertical, only $83 ($700 spread width minus $617 credit) is the time value differential between the short and long legs, so how much are you going to gain due to IV changes when most of the spread value is intrinsic and not effected by it?  Same holds true for DITM SDS vertical.   When dealing with OTM verticals, IV can have more of an effect since all of the value is non-intrinsic - but in this case rising IV helps a debit vertical (ie. farther OTM spreads are worth more), so rising IV would hurt a credit vertical for the same reason.  

I'm not saying that this trade is good or bad, I'm merely stating that SPY and SDS price movement is going to affect the vast majority of this trade's gain/loss.  IV changes are not going to affect it much at all since such a small percentage of the spread width is based on non-intrinsic value.

Edited July 21, 2016 by Yowster

[Davidkot81 11]

Certainly true for spy as it is very deep in the money.  I think sds less so since it's only slightly in the money.

 

at any rate I will backtest further

 

ps

 

with spy a mostly extrinsic value spread the iv rank being 0 is less relevant.  Whereas in sds the iv rank is relatively rich at 50% and the skew helps your trade as well.  

Edited July 21, 2016 by Davidkot81