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Index puts: reaping option premium with ratio spread

S&P 500 index puts most of the time are overbought. Let’s take a look at the picture with Cognitum Option Pricer for the current state in SPXpm contract with expiration 15 August:

As you can see, market/model ratio grows when strike price moves down and it reaches hundreds when contract is not yet overly cheap. Selling those puts should give us a very tasty mathematical expectation of profit.

Unfortunately, selling naked puts is highly dangerous adventure, because sudden and strong downside can skyrocket the puts price.

We can limit the risks with delta hedging using index futures. That’s definitely a solution, but the problem is calculating real delta of put position. What do we have is a “market delta”, calculated from observing option chain prices. This is not a good estimate, because when market moves, put price is influenced not only by price change, but also by volatility change, which in case of an index is correlated with price change. So we have to calculate corrections to market delta to get real delta, one way to do it is described here.

There is more convenient way to hedge the put position – using different puts, with strikes closer to money and hence less overbought. This kind of combination is called “ratio spread”. Here is an example of 1:3 ratio spread:

We reap $223 of premium (Market / Total) with a position being delta-neutral (see Market delta / Total).

We can expect that volatility changes will influence the same way both legs, so we don’t have to worry about delta corrections, because what matters here is a relative ratio of deltas.

Moreover, this kind of hedge will slide apart more slowly, requiring less efforts correcting the position and saving us transactional costs.

If you’re unlucky enough to trade options with InteractiveBrokers of some other broker with full-size margin requirements on option sells, you margin adjusted results may be unimpressive, or you’ll be forced to sell too close near-the-money puts which is less effective and requires fast reaction on market downsides. What you can do is selling credit spreads instead of selling puts on far leg of the combination. You can check how overbought a credit spread is in the column “Delta ratio”. As you can see it’s not so tasty as puts, but still interesting. With this 3-leg combination you may rise your margin-adjusted results in 2-3 times.

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