Over the last month and half, technical signals have proven to be false or extremely short lived. So how do you trade the traditional, conservatively positioned vertical spread when the broad market indices are in a craze?
The first question you have to ask yourself is, “Does it makes sense to be trading these positions at all right now?” The truth is, while the Option Workshop focuses on vertical spreads, the trade makes more sense in some environments than others.
But right now is in fact, a good time for verticals. Since implied volatility is high (both in the at-the-money and out-of-the-money strikes), vertical spreads can generally be positioned at top dollar and/ or further away from price than normal. On the other hand, volatility is high for a reason – price is moving around a lot. A trade positioned well out-of-the-money today, may find itself at-the-money three days from now.
While there are several different ways to address this situation and each trade is unique, the approach I’d like to discuss today is hedging the vertical spread with opposing verticals – essentially condorizing (or “bufferfly-itizing” in some cases) the position. The idea is to reduce the deltas of the original trade to rely less on the directional movement of the underlying and more on premium decay while still maintaining some degree opinion on direction. For this to work, the different sides of the position need to be established when volatility is high. In some cases, this may mean constructing the trade as some sort of condor at inception and in other cases, it may mean legging into this type of trade day by day while managing risk.
Here’s what I mean. Notice in the skew chart below that the volatility of the 500 strike is extremely high compared to the strikes around it (the 495 strike is also high).
This option is in high demand and buyers are bidding up the price more than its fair value. Sometimes this is just a momentary anomaly that is quickly corrected, but other times these pricing discrepancies can be traded. What you want to do is sell that expensive option and buy the comparatively cheaper 505 strike. So in this example, let’s say you already have on 10 contracts of a 450/460 bull put spread and you’re down about 8% or so. You might then buy 2 contracts of the 500/505 bear put debit spread to hedge the position, knowing that you are trading this bear spread for a steal. Your resulting position might look like so:
The benefit of putting on this hedge at this kind of price is that if the underlying reverses course and rallies over the next day or so, the bear spread has a built-in extra 20 or 30 cents of edge. While the underlying is rallying, this spread has wiggle room because it was purchased at a discount.
Using this same logic, one might sell the 550/ 560 bear spread at really nice price based on the skew chart above to establish the unbalanced condor below:
A combined position with both of these hedges is shown below. Notice that the overall trade is still a very simple position that can be easily managed.
While it certainly helps to view a skew chart or each strike’s IV on an option chain to determine the fair value of an option’s price, these kinds of trades can be done even without this data. The basic premise is that if implied volatility is high in the at-the-money strike, then an ATM vertical spread is probably a good trade. If implied volatility is high in the out-of-the-money strikes (this may be at different times for calls and puts), then an OTM spread is a good adjustment (and I should say, buying out-of-the-money longs is a bad adjustment).
In this is example, we walked thru hedging an established position with bear spreads to manage risk. But this type of hedging need not wait until after the initial position is already established. Depending on your forecast of price and volatility, it may very well make more sense to put on the initial vertical spread position as an unbalanced condor or some sort of variation right at the beginning.