India 2020 From Strategy to Practice - Amazon S3...Low IVR (
Transcript of India 2020 From Strategy to Practice - Amazon S3...Low IVR (
with Tom Sosnoff
From Strategy to Practice
India 2020
Today’s Agenda
Turning Uncertainty and Fear into Opportunity:Making Option Theory & Implied Volatility Tradable
Today’s AgendaUnderstanding IVR
Strategies for Different Levels of IV
Advanced Portfolio Diversification
Extrinsic Premium Overstatement
Optimal Deltas for Strategic Probabilities
Trade Small / Trade Often
Understanding Implied Volatility Rank (IVR)
Our objective is to create tradable edge selling premium when it is most expensive.
Implied volatility as a stand-alone number does not offer much insight with respect to whether premium is currently expensive relative to itself.
IVR places context around how implied volatility is measured compared to the last 52 weeks, letting us know if premium is expensive or not.
Understanding Implied Volatility Rank (IVR)Understanding the differences in implied volatility vs. implied volatility rank
Implied volatility rank - IV rank simply tells us whether implied volatility is high or low in a specific underlying based on the past year of IV data.
For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%. Since all underlyings have unique IV ranges, stating an arbitrary IV number does not help us decide how we should proceed with a strategy.
Understanding Implied Volatility Rank (IVR)Understanding the differences in implied volatility vs. implied volatility rank
Implied volatility - IV is determined by the current price of option contracts on a particular stock or future. It is represented as a percentage that indicates the annualized expected one standard deviation range for the stock based on the option prices.
For example, an IV of 25% on a $200 stock would represent a one standard deviation range of $50 over the next year.
Understanding Implied Volatility Rank (IVR)
When IVR is inexpensive, premium collected is not sufficient relative to the risk being assumed in a trade.
Conversely, when IVR is elevated, premium collected sufficiently compensates us for the trade risk.
Understanding Implied Volatility Rank (IVR)
20
Debit Strategies Short Premium StrategiesEither Debit or Short Premium
30
SPY 45 Day Periods
IVR
Below 10 Between10 & 20
Between20 & 30
Between30 & 40
Between40 & 50 Above 50
Average Move in IV
(VIX)+1.2 +0.8 +0.3 -1.4 -4.2 -7.9
Understanding Implied Volatility Rank (IVR)
Strategies for Different Levels of IV Rank
Different market environments require different strategies.
Strategic decisions are dictated by cost of premium relative to itself.
When IVR is elevated (>30) we are premium sellers
Low IVR (<20) we lean more on static, horizontal or debit strategies
Between 20 - 30 is more of a gray area though we tend to lean more toward selling premium.
Strategy Ideal IV EnvironmentShort Naked Put / Call High
Short Put / Call Vertical Spread High
Short Strangle / Straddle High
Short Iron Condor / Iron Fly High
Jade Lizard High
Front Ratio Put / Call Spread High
Long Put / Call Diagonal Spread Low
Long Put / Call Vertical Spread Low
Strategies for Different Levels of IV Rank
Strategies for Different Levels of IV Rank: Low IV
Calendar – Buying the back-month option then selling the same front-month option for a debit.
Diagonal – Buying an in or at the money back month option and selling a further out of the money front month option. Typically, done with a month between the short and long positions.
Put Debit Spread – Buying an in or at the money put and selling a further out of the money put in the same month.
Strategies for Different Levels of IV Rank: Low IV
Call Debit Spread – Buy an in or at the money call and selling a further out of the money call in the same month.
Reverse Jade Lizard – Selling a naked call and a put spread with no risk to the downside.
Covered Call – Buy stock and sell an out of the money call.
Strategies for Different Levels of IV Rank: High IV
Strangles – Selling an out of the money put and call.
Straddles – Selling an at the money put and call.
Ratio spreads – Buying an at the money put (call) then selling two or more further out of the money puts (calls).
Strategies for Different Levels of IV Rank: High IV
Butterflies – Buying an at the money put (call), selling two further out of the money puts (calls) and buying an even further out of the money put (call). Essentially a defined risk ratio spread.
Jade Lizard – Selling an out of the money put and out of the money call spread with no risk to the upside.
Covered Call - Buy stock and sell an out of the money call.
Advanced Portfolio Diversification
Asset Class Diversification
Strategic Diversification
Volatility diversification
Time Diversification
StocksFutures
Average correlation of gold, bonds, oil, euro, and emerging markets to SPY
In late 2008 0.51
In mid 2019 0.33
Advanced Portfolio Diversification: Stocks
Correlation among assets gets closer to 1 or -1 as prices fall.
Advanced Portfolio Diversification: Futures
Larger notional products
Offer significantly greater capital efficiency
Can be segmented into two broad categoriesCommoditiesCurrencies
Advanced Portfolio Diversification: Futures
Pairs trading is the use of two correlated products simultaneously. For example: Selling /ES and buying /NQ
Benefit of pairs trading is reduced risk and lower volatility of returns.
Drawback is there is no cross-product margin relief so both positions must be funded.
Straddle 1
Strangle 0.9 1
Call Spread 0.2 0.0 1
ATM Put 0.3 0.4 -0.7 1
Straddle Strangle Call Spread ATM Put
Advanced Portfolio Diversification:Strategic Diversification
Extrinsic Premium Overstatement
Intrinsic premium is the amount by which an option is in the money (ITM).
Extrinsic premium represents the market’s perceived potential value of an option based on implied volatility, days until expiration (DTE) and dividends.
Because implied volatility tends to overstate realized volatility, extrinsic premium tends to also be overstated.
Extrinsic Premium Overstatement
Implied volatility
Realized volatility
Implied volatility represents the market’s expected range for an underlying. Forward looking
Is the actual movement in priceBackward looking
Extrinsic Premium Overstatement
Implied VolatilityRealized Volatility
Probability of Expiring ITM at ExpirationSPY Strangle
45 DTE Expected Actual
16Δ 32% 25%30Δ 60% 57%
Extrinsic Premium OverstatementOver the course of the last ten years, we see both 16 and 30 delta strangles overstate actual price moves. This is despite being short calls in a strong bull market.
Extrinsic Premium OverstatementA further breakdown shows that although call premium slightly overstated realized volatility, put premium significantly overstated.
Probability of Expiring ITM at Expiration
SPY 45 DTE Expected Actual
16ΔCall 16% 20%
Put 16% 5%
30ΔCall 30% 45%
Put 30% 11%
Extrinsic Premium OverstatementBecause markets are random, we prefer to hedge our risk by not relying too much on directional trades and employ more neutral strategies.
Even in a parabolic move higher, short call premium tends to overstate actual price moves and put premium significantly overstates.
This suggests a neutral premium selling approach can be successful and even in one-directional markets, our performance is enhanced when we take advantage of premium overstatement for both puts and calls.
Optimal Deltas for Strategic Probabilities
Where we place our deltas for short premium trades dictates both profit potential and how much time we can expect to be in a trade.
Delta placement is also affected by IVR.
Although IVR does not change the statistical probabilities of success, it does affect our potential P/L.
We want to find a balance between risk assumed and profit potential.
2005 to PresentS&P 500 (SPY) Strangles (45 DTE)
30 Delta 16 Delta 5 Delta
Avg. Days to 50% of Max Profit 27 Days 21 Days 17 Days
Optimal Deltas for Strategic Probabilities
The closer we place our trade to ATM (at the money), the longer the duration we will be in the trade.
Optimal Deltas for Strategic Probabilities
Optimal Deltas for Strategic Probabilities
The closer to ATM had the highest P/L while the further out had the highest win rate.
2005 to PresentS&P 500 (SPY) Strangles (45 DTE)
30 Delta 16 Delta 5 Delta
Win Rate 81% 90% 97%
Average P/L $65 $36 $10
Optimal Deltas for Strategic Probabilities
When IV was high, we saw a faster turn around on larger profits, but the 5 delta seemed hardly worth it.
IV Rank over 50%2005 to Present
S&P 500 (SPY) Strangles (45 DTE)
30 Delta 16 Delta 5 Delta
Win Rate 83% 90% 95%
Average P/L $85 $38 $5
Avg. Days to 50% 25 Days 19 Days 14 Days
Optimal Deltas for Strategic Probabilities
IVR does not impact win rates by a noticeable amount.
P/L is significantly different for varying levels of IVR.
When IVR is higher, we see a much higher average P/L per trade.
Strategically placing our deltas and capitalizing on high IVR are key to improving performance.
*1 SD strangle, SPY, 45 DTE since 2005. Managed at 21 DTE.
Optimal Deltas for Strategic ProbabilitiesAs IVR increases, our P/L increases as well while our success rate stays relatively the same.
S&P 500 (SPY)16Δ - 45 DTE
IVR
0 to 25 25 to 50 50 to 75 Above 75
Average P/L $34 $43 $62 $72
Success Rate 84% 77% 79% 77%
Trade Small / Trade Often
In order to create the greatest probabilistic chances for success, we need to create multiple occurrences using both uncorrelated underlyings and diversified strategies.We also want our trade size to reach a balance between being able to move our P/L needle but also not being able to blow up an account.As we create more occurrences, our P/L benefits from a lower standard of deviation of returns.
Trade Small / Trade Often
Market volatility determines what percentage of capital we use.
Individual trade sizing as a percentage of net liq.
No more than 15% of net liq in any single underlying.
Undefined risk: 3 - 7%Defined risk: 1 - 3%
VIX is greater than 40 50% max allocation of BP
VIX is between 30 and 40 40% max allocation of BP
VIX is between 20 and 30 35% max allocation of BP
VIX is between 15 and 20 30% max allocation of BP
VIX is between 10 and 15 25% max allocation of BP
Trade Small / Trade Often
Trade Small / Trade Often
75% allocated to undefined risk strategies(No more than 3 to 7% per trade)
Straddles (higher IV Rank)Strangles (lower IV Rank)
25% allocated to defined risk strategies(No more than 1 to 5% per trade)
Iron Condors Debit and Credit spreads
Trade Small / Trade Often
Trade Small / Trade Often
Increasing sample size makes the win rate, as well as other statistics, approach a more stable, accurate level.
10Trades
100Trades
1000Trades
AllTrades
Avg. P/L per Trade $121 $85 $63 $67
Standard Deviation $340 $181 $272 $220
Win Rate 70% 73% 83% 83%
Trade Small / Trade Often
As number of occurrences increase, the sample’s averages move closer to the averages of the true value.