Considering Our Options – What Structures are Working in this Market?

by CC March 8, 2013 12:55 pm • Commentary• Education

With the markets seemingly drifting higher every day it’s a good time to reflect on some of our recent trades to determine what’s working in the market and what isn’t. A great way to do that is looking at the P&L of recent trades and then taking a look at vol charts in the overall market to see why some things are working and others aren’t. Here’s a 6 month IV30 (red) vs HV30 (blue) chart in the SPX:

IV30 vs HV30 from LiveVol Pro

What you’ll notice is a fairly low actual vol with temporary spikes in implied volatility. The other thing worth noting is how consistently actual vol has been lower than the implied vol in the market. You may hear traders say that when vol is low you want to “own premium” with the assumption that vol will eventually tick higher towards its historical means. The problem with that advice is that a market that is drifting higher with only brief periods of spikes in volatility from pullbacks gives you long periods of decay with brief pops in premium that aren’t enough to get out of rotting long premium positions.

Our recent trading reflects this in P&L. What hasn’t been working is picking directions in trades with long premium plays. What has been working is selling gamma. (short near term options) When we’ve sold gamma in names either through the use of calendar spread (selling near term options, buying longer term options) selling iron condor/fly structures and buying in-the-money flies that act like synthetic short premium trades, we’ve fared much better. What ties all these trades together is that all of them benefit from the daily decay in options and collapsing IV in the market.

I wanted to highlight one structure in particular that you’ve probably noticed us trading alot. The In the money butterfly. Here’s a trade Enis initiated yesterday in Sodastream:

TRADE: SODA ($49.20) Bought Apr 45/50/55 Call Butterfly for $1.65
  • Bought 1 Apr 45 Call for $5.19
  • Sold 2 Apr 50 Calls at $2.14 each
  • Bought 1 Apr 55 Call for $0.74

Although this structure costs 1.65, it is actually a short premium trade from a gamma and theta perspective. The easiest way to see this is by looking at what the structure cost vs. what the trade is intrinsically worth at he time of the trade. With the stock at 49.20 the fly is intrinsically worth 4.20 as it’s 80c from the guts of the fly. (on expiration with the stock at 49.20 the 45 calls are worth 4.20 while the 50 and 55 calls are worthless.) Meaning if expiration was at the moment of the trade, it could be taken off for 4.20. What that means over time is if the stock stays in range, and assuming IV doesn’t move, each day that trade gains from the effects of theta/decay. As we get close to its expiration that rate of decay increases. Here’s a trade that we still have on that illustrates what happens over time in one of these ITM flies:

Trade: QCOM ($66.50) Bought the Apr 70 / 65 / 60 put fly for $1.50
  • Bought 1 Apr 70 put for 4.68
  • Sold 2 Apr 65 puts at 1.92
  • Bought 1 Apr 60 put for 0.66

With the stock at essentially the same place that structure is now worth 2 dollars. That change of 50c in our favor is a result of decay in the premium of the options as we get closer to expiration. (the structure moves towards intrinsic — 3.50 at time of trade — value over time )

Another structure that’s had some success recently is the calendar spread. Let’s take a look at a trade we did where both decay and collapsing vol have taken a toll on the premium of a trade:

TRADE: Bought the TSLA ($37.50) Mar / Jun 40 Call Calendar for $1.60
  • Sold 1 Mar 40 call at $1.60
  • Bought 1 Jun 40 call for $3.20

With the stock a dollar higher than where we initiated the trade the March 40 calls are now 25c while the June calls are about 2.20. As you can see from those current prices a long premium long gamma trade would have gotten murdered. But since that structure included a short gamma front month call it’s been able to absorb the collapse in volatility and the effects of decay to the point where it’s a small winner.

Now let’s look at a loser:

Trade: Bought the HD ($66.92) May 65 / 60 Put Spread for $1.22
  • Bought 1 May 65 put for 2.06
  • Sold 1 May 60 put at 0.84

Soon after we put on this trade we actually had a profitable move in the stock as HD sold off before its earnings. The problem, aside from the fact that that selloff quickly reversed and we didn’t take profits in the trade was that we needed the stock to move a decent chunk to make up for the decay and collapsing vol of the trade following earnings. We had a brief moment of profitability followed by a premium crushing pop and subsequent drift higher. Pretty much the market of the past few months in a microcosm.

So what this means is until the market’s trend changes and volatility spikes for more than a few days at a time, the best defense is to be either short gamma outright in the form of defined risk range trades (ITM flies are great for this) or if wanting to get long volatility at such low levels, selling near term gamma as a defense against killer decay in the form of calendars.

This is obviously a strategy that works until it doesn’t. What would change is if the market hit turbulence for any sustained period of time at which point the actual volatility could be much higher than what options are pricing. In that case long gamma is the preferred structure. But until that happens it’s best to be on defense as far as decay goes.