QUESTION: How can you profit from a volatile stock positively skewed to the downside while keeping your risk defined?
ANSWER: Establish a put ratio back spread
A back spread is an options spread in which the trader has a net long options position. This can be accomplished by being long more options than short, or proportionally more than the underlying product. If you are back spreading calls, you are long more calls than you are short stock, ETFs or futures. If the trader is back spreading puts, then he or she would be long more puts than long the underlying. A simple long straddle or strangle where the trader is long both calls and puts would be considered a back spread. A back spread has a defined amount of risk in the position. Because a back spread is net long options, there never can be unlimited risk in the position.
In an ideal back spread scenario, the underlying market experiences wild gyrations. The net long options profits keep increasing with each incremental move in the underlying, whichever direction that happens to be. In a nightmare scenario the underlying just sits within a very narrow trading range. The time value that is embedded in the option premium steadily erodes, as does the trader’s account.
To understand back spreading, a trader also must understand volatility skew. Before that, a trader must understand the meaning of implied volatility. Historical volatility shows the movement of an underlying instrument over a certain time period. This can be accomplished by measuring the variance of returns of the underlying. The greater the trading range over a period of time the greater the historical volatility.
Implied volatility is a reverse engineering process whereby the price level of the time value that is embedded in an option premium indicates where the future volatility of the underlying instrument is expected to be. Every options trader in the world has a vote. Aggressive premium buying results in a high implied volatility, while aggressive premium selling results in a low implied volatility. Implied volatility is at its highest during times of uncertainty. The period immediately prior to earnings reports, crop reports and economic reports is when implied volatility is at its highest depending upon the underlying instrument.
Volatility skew refers to the difference in implied volatility among the at-the-money, out-of-the-money and in-the-money options. When out-of-the-money options have a higher implied volatility than at-the-money options, it is known as a positive skew. When out-of-the-money options have a lower implied volatility than at-the-money options, it indicates a negative skew.