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.
Let’s take a look at IBM’s pricing. With the stock trading at $192.95, the July 170 puts, which are $22.95 out-of-the-money, are trading at $3.50. The July 215 calls, which are $22.05 out-of-the-money, are trading at $2.00. This means that IBM options are positively skewed to the downside and negatively skewed to the upside; 99% of stocks are skewed that way. Options on agricultural futures usually are positively skewed to the upside and flat or negative to the downside.
When the trader is constructing an initial position, being net long puts makes sense. Going long three of the July 170 puts at $3.50 and short two of the July 180 puts at $5.60 is a good example. If IBM closes at the July expiration at $180 or above the trader profits 70¢($70). No harm, no foul. If IBM closes at $170, the trader loses $17.30 ($1,730). That’s a fair amount of harm for a simple 3x2 spread. If IBM closes at $150, the trader is back to the 70¢ profit. Below that price point is all gravy. There is almost a 30-point range where the put back spread is unprofitable.
That, however, is taking into account only what happens to the untouched position at expiration. While 10% of profits usually are derived from establishing a sensible initial position, the other 90% comes from knowing how, when and why to adjust that position.
With this position, if the stock starts heading south, the position instantly will become profitable. The implied volatility for all options will increase with a sharp downside move. Because the trader has a net positive inventory of put options, that inventory will be priced higher. The trader then either can unwind the position for a profit or adjust it by selling some puts at a much higher implied volatility. Buying low and selling high works the same for implied volatility as it does for market direction.
Dan Keegan is an instructor with the Chicago School of Trading. Reach him at email@example.com.