Can we trade the (vertical) skew?

[cuegis 683]

We all know that the vast majority of equity, and equity/index/ETF - related options all have a (vertical) price skew that is heavily weighted to the downside strikes, which are trading at much higher implied's than upside strikes.

This always remains the same. It just becomes more exaggerated when IV as a whole, goes up, as a result of a down move in the market.

It is pretty much always the case that a downside, out of the money, strike, that is equal distance from "at - the -money", will be much more expensive than an upside strike the same distance away.

And the skew gets wider the further out of the money you go in both directions.

This is not news....everybody knows this.

What I am trying to get some ideas about is whether there is a viable (profitable) way to sell the overpriced (lower) strikes, and buy the under priced (higher) strikes, in a delta neutral context, to take advantage of the skew.

I have plugged a bunch of the most liquid vehicles into various "P/L" programs to see what they would look like (ex. "Analyze in TOS).

Since there is no difference between a put and a call, when trading delta neutral. There are only different strikes and expirations. An out of the money put is only an in the money call etc.

I took SPY, for example, and sold a 200 call ( which is basically a 200 put for IV purposes) with an IV of 23%. Then, bought (11 for every 1 sold)  of the 224.50 calls with an IV of 7.5%, making it delta neutral.

Selling 23 IV and buying 7.5 IV, in the same series.

Then looked at the P/L graph.

I never know whether or not . Or, when or not, to take these P/L graphs seriously because of the huge differences in IV's.

But, this P/L shows a slight profit to break even from the current price going down in price movement.

And a massive gain on any up move.

It looks very impressive so I tried the same thing with a number of individual stocks, indexes, and ETF's and they all come out with the same P/L graph.

And, remember, this is the very worst time to be doing this sort of thing because we are at historical (IV) lows all around, which makes the skew less exaggerated.

But, it still shows up as a profitable outcome across many different underlyings, despite the low IV, and flatter skew.

I just want someone to tell me what I am missing. Or whether , like in many other situations, just ignore the P/L graph.

Or, is this something worth pursuing?

[dbh21 62]

I think this is interesting. This is a ratio spread that you are picking based on IV. 

I don't quite understand why you would make this delta neutral. The downside is positive, the upside is negative for 0-3% or so. Would you rebalance to keep it DN?

When would you place this trade? It seems you need to have an opinion on the market moving down or large to the upside

Also since its vega positive, in the low vol environment we are in has a bump - that should benefit it.

[cuegis 683]

I only started thinking about this in the past week so I have not REALLY dug into all the possibilities.

I just started playing with the basic idea, which is to buy low IV, and sell very high IV in the same expiration.

To stick with the original idea, I need to , at least initially, keep all other variables constant, so I don't go off down another , unintended, track.

It was not meant to be a "backspread" (the opposite of a ratio).

It just turned into one because of the logistics of getting me to delta neutral.

Most people would think of selling the deep, out of the money, downside, in terms of selling puts.

But, a deep out of the money put, is just a deep , in the money call, for IV purposes.

If I sold deep out of the money puts (long delta), and then bought, cheaper, out of the money, upside calls (long delta), then I would be long delta twice.

The only way to get to delta neutral would then be to add an uneccesary, 3rd leg by selling the underlying to neutralize it.

So, just sell the deep in the money call, it is the same thing and you can keep it to 2 pieces instead of 3.

The unintended consequence of keeping this delta neutral is having to buy so many more , low delta, calls, than the .95 delta call that you are selling.

The whole thing just backed itself into this position as an after thought.

But, now that it is there, it does gain all of the benefits of a backspread...on steroids, since it is 11:1. But the $ credit is so huge that it protects you for a wide range as an added benefit.

This is just the start of an idea.

It may prove that it is not worth pursuing. Or, it may lead down a path to something with a LOT of potential.

It all starts with the fact that I can't stand looking at a , for example, 45 IV, equal distant to the downside of ATM, and a 20 IV the same amount odf strikes away, to the upside.

There HAS to be something that can be done with this imbalance.

Since ALL IV's =0 at expiration! So, it WILL work itself out over time.

[Kim 8,043]

In your example, which expiration you referred to? You still need a move to make a profit because the trade is theta negative. The P/L chart is not much different from straddle.

[cuegis 683]

This is just an example I plugged in without spending a lot of time pursuing the best candidates, and the best refinements.

I just threw in a fairly generic idea.

But, as you can see, it does not resemble a straddle at all.

A straddle is a "smile" (long) or "frown" (short) that is very much equal in both directions.

This is a (profitable), and horizontal line, to the left, and yes, to the right, it does resemble the ongoing gains of a long straddle.

But there is little to no theta decay throughout 99% of this picture.

This is not a picture that resembles a long straddle.

Remember, all of these potential gains are not even what we are looking for.

This process started as a way to benefit through the IV "skew" going flat at expiration.

Any other benefit is just the result of the logistics of how to capture the skew differential.

Anyway, relative to the numbers involved (and this is a 1 lot (1:11)), any time decay is almost non-existent.

 

 

Initial outlay: $1712 (net credit) 

 

 

Strike	24 Aug	27 Aug	30 Aug	2 Sep	5 Sep	8 Sep	11 Sep	14 Sep	17 Sep	Current
180	1,710	1,711	1,711	1,712	1,712	1,712	1,712	1,712	1,712
182	1,707	1,709	1,710	1,711	1,712	1,712	1,712	1,712	1,712
184	1,702	1,706	1,708	1,710	1,711	1,712	1,712	1,712	1,712
186	1,694	1,699	1,704	1,707	1,710	1,711	1,712	1,712	1,712
188	1,680	1,688	1,695	1,702	1,707	1,710	1,712	1,712	1,712
190	1,659	1,670	1,681	1,690	1,699	1,706	1,711	1,712	1,712
192	1,628	1,642	1,657	1,671	1,684	1,697	1,707	1,712	1,712
194	1,584	1,602	1,620	1,639	1,658	1,677	1,695	1,709	1,712
196	1,525	1,546	1,567	1,590	1,615	1,641	1,669	1,698	1,712
198	1,449	1,472	1,496	1,522	1,550	1,582	1,618	1,663	1,712
200	1,356	1,379	1,404	1,431	1,461	1,495	1,535	1,587	1,712
202	1,244	1,267	1,292	1,318	1,347	1,379	1,416	1,462	1,512
204	1,116	1,137	1,159	1,183	1,208	1,236	1,265	1,296	1,312
206	971	990	1,009	1,029	1,050	1,071	1,091	1,107	1,112
208	813	829	845	861	876	891	903	910	912
210	643	656	669	681	692	701	708	711	712
212	464	474	484	493	500	506	509	511	512
214	290	286	293	299	304	308	310	311	312
216	121	116	110	103	106	108	110	111	112
218	4	-14	-43	-62	-82	-92	-90	-89	-88
220	28	-35	-98	-151	-205	-247	-279	-289	-288
222	292	196	87	-21	-130	-249	-358	-456	-488
224	918	788	658	516	363	189	-19	-282	-688
226	1,951	1,832	1,712	1,570	1,428	1,276	1,101	904	762
228	3,369	3,271	3,184	3,086	2,999	2,913	2,837	2,783	2,762
230	5,061	5,007	4,953	4,899	4,856	4,814	4,793	4,772	4,762
232	6,929	6,897	6,865	6,844	6,823	6,803	6,793	6,772	6,762
234	8,885	8,864	8,843	8,833	8,812	8,803	8,793	8,772	8,762
236	10,874	10,853	10,843	10,822	10,812	10,803	10,793	10,772	10,762
238	12,863	12,853	12,843	12,822	12,812	12,803	12,793	12,772	12,762
240	14,863	14,853	14,843	14,822	14,812	14,803	14,793	14,772	14,762
218.61										-2,243.1
218.61										16,418.1

 

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Edited August 24, 2016 by cuegis