Wednesday, July 16, 2014

Preparing for a market correction with far OTM calls sells

What are the ways to bet on volatility rise in S&P 500? You may first think of put buying or VIX products buying. The problem with these positions is they are expensive. Everyone is buying puts just in case, so they are overpriced, sometimes tens of times from the model. VIX products are not cheap either, having average trend against long. Even direct and straight way – index shorting – will play against you, because on low volatility market growth is strongest.

There is another way – far OTM calls selling. This approach has several advantages:
  
1. Option time decay works on you.
2. When volatility is low, calls are usually overbought (at least comparing to the Cognitum Option Pricer model), selling them is mathematically justified.
3. Index behaviour on market growth is fairly predictable - there are trend lines which work as barriers.

I would like to illustrate the last point. Let’s take a look at the current state of S&P 500:






Blue vertical lines are expiration dates of SPXpm contracts.

There are two trend lines from different timeframes, they "limit" the index growth. The probability of a strong growth above those lines is fairly low. So selling calls with strikes 10-20 higher those lines can be safe enough. It is better to sell it when market approachs the lines and stabilizes in slow growth on low volatility.

For more cautious traders who is uncomfortable having naked sells I can recommend hedging with buying far calls on contract 1-2 month later, same position size. In case of a strong growth profits from far expiration will compensate losses from closer expiration, and time decay will be your profit.

If your broker requires a lot of margin to sell options, you may try to sell vertical spreads instead, though this position will be less effective and transaction costs will be higher.

2 comments:

  1. I am really surprised that you found calls are undervalued. Using a similar an option model similar to your product, I found puts to be overvalued almost always and calls to be undervalued during low volatility regimes. The undervalue-ness of calls are even more persistent for calls expiring more than 1 year away.

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    1. It is possible to have different estimates for different normalization window lengths. I use one I've tested to be ok for contract durations of my interest.

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