Low volatility got you down? No need for Debbie Downer. You got options, baby. Just put the credits to rest for a spell and try a debit play or two. Last week I touched on using calendars to play the low VIX levels. Today I want to throw out another idea that not only games the low implied volatility, but also volatility skew. Plus, it’ll add some negative delta to your portfolio to hedge against any kind of market correction over the next couple of months.
Bear put spreads might be just the ticket here. The vertical debit spread consists of buying to open a higher strike put while selling to open a lower strike put in the same expiration cycle. The premium received from the short put reduces the overall cost of the trade. And since the net cost is the max loss in the position, the put spread is a much less risky way of acquiring protection than a straight up put buy.
The low VIX is keeping a lid on option premiums making the cost of the bear put quite tame. The cheaper the cost, the less the market has to fall before your put spread really starts rolling in the dough. With the SPY at $206.25, suppose you buy the June 205/200 put spread for $1.50 or so. That is, buy the Jun 205 put while selling the Jun 200 put.
The max loss is limited to the initial $1.50 debit and will be forfeited if SPY is above $205 at expiration. The max gain is limited to the distance between strikes minus the net debit, or $3.50, and will be captured if SPY sits below $200 at expiration.
By risking $1.50 to make $3.50, the spread offers a 233% return. And that’s if SPY falls a mere 3% from here. Why, hello leverage. By going out to June we give the market 74 days to stage some type of pullback following its rocket ship rise.
On to volatility skew., which is a topic that definitely merits some further commentary. Perhaps another time. Here’s the short version. Implied volatility reflects the amount of demand for an option. The higher the demand the more expensive the option. And the more expensive the option the higher the implied volatility. Since the demand for every strike price is different they often boast varying implied volatilities. This variation in volatility from one strike to the next is often referred to as volatility skew.
Since demand for out-of-the-money puts usually exceeds demand for at-the-money puts, or calls for that matter, the implied vol gets gradually higher as you move further OTM.
By design the bear put spread capitalizes on volatility skew by purchasing a lower volatility option and selling a higher volatility option. See the accompanying chart for illustration.
Just something to consider for those wondering what types of plays makes sense in this environment.
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