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Tales of a Technician: Low Vol + Skew = Bear Put Paradise

April 6, 2016

By | 13 Comments

Vol skew

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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13 Replies to “Tales of a Technician: Low Vol + Skew = Bear Put Paradise”

  1. Avatar LINDAFOSTER says:

    You speak to my concerns and instinct. Well done once again Tyler! Bear Puts here I come . . .

  2. Avatar JoanNee says:

    Ah yes! Frankly, I had no idea… but now I do. Thank you Tyler. This goes in my playbook now. Much appreciated.

  3. Avatar Sundar says:

    Thanks for the insight Tyler. Will paper trade this one and follow it through to see how we do on this one.

  4. KEITHGIUNTA KEITHGIUNTA says:

    This was new….thanks Tyler.

  5. Nicholas Kingsbury Nicholas Kingsbury says:

    Thank you.

  6. Tyler, I got one question:

    What would be the best DTE setup for this debit spread trade?

    I mean, I have a long-term protective put on SPY, securing my whole portfolio (paper account): 5 contracts of the JAN 17 180 puts (289 DTE).

    Will it be a good play to sell 5 of the 175 puts to form a long-term bear put spread? Or does it only work well on the short-term?

    Thanks in advance. I’m your fan.

    1. Avatar Tyler Craig CMT says:

      We usually teach using about three months to give yourself plenty of time for the drop to materialize. If I were using the Bear Put for long-term portfolio protection I would do a wider spread than $5. So maybe a 180/165 or 180/160 or even wider. I wrote an article on March 2nd titled The Trick for Financing Portfolio Protection that fleshes out the idea. Go take a look.

  7. Thanks for the synopsis on skew at the end of the article, and for some actionable ideas. I would love to learn more about skew “Tylerized.” Thanks for always keeping things digestible.

    1. Avatar Tyler Craig CMT says:

      Mmmm… “Tylerized” I like that. Will add to the to-do list.

  8. Avatar BONNIELEAHY says:

    You are adding a lot of value to Tackle Trading and continue to be a “Must Read”. Thank you!

  9. Avatar ERICSIMMS says:

    Great advice!

  10. Avatar CYNTHIABLACKWELL says:

    So clear and helpful. I understand BPS in a way I never have. Thanks very much!

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