With the majority of options expiring worthless, many traders are interested in selling options. Options are a wasting asset. With no change in any of the underlying assumptions, an option will lose part of its value every day until the option expires worthless. Time only moves in one direction, so an option seller benefits from the effects of time decay every day. The option seller, however, must protect against a large adverse price move, as well as an increase in implied volatility.
Many traders start out selling premium by shorting out of the money calls or puts, sometimes both at the same time. Statistically speaking, this can be a profitable strategy for a period of time, as the majority of out-of-the-money options will expire worthless. The problem comes when the underlying market makes a large move in one direction and months, if not years, of profitable trades are erased.
We will discuss two different types of spreads in which the trader is net short premium. The first type of spread will be a defined or limited risk spread and the second type will be a spread with unlimited risk. There are different ways to structure both types of spreads. We will offer some different ideas that the trader can build on. As a note, many traders are frightened by the term “unlimited risk”. But keep in mind, any outright futures trade has unlimited risk with a 50% chance of profitability. Many unlimited risk option spreads have far better statistical odds of profitability with the same or even lower risk.
Implied Volatility & Implied Volatility Skew
Volatility is very important in option trading. Today we will refer to Implied Volatility and Implied Volatility Skew. Implied volatility is the option market’s best guess at how volatile the underlying futures contract will be during the remainder of the option life. For example, we would reasonably expect implied volatility in corn to be greater in May, ahead of the critical pollination stage, than we would in November, after the crop has been harvested. Corn price volatility is usually more volatile in the spring and summer, as weather is a large unknown. At the end of the season after the corn crop has been harvested, there is generally less uncertainty and therefore less price risk. This is typically reflected by lower implied volatility in corn options in the fall. The grain markets in general have observed seasonal tendencies in implied volatility. Also, the energy markets have seen a tremendous increase in implied volatility across their option markets. This has been brought about by the great uncertainty in the supply chain that started with the Iraq war and has been exaggerated by Hurricane Katrina.
We will focus on implied volatility skew (skew) while reviewing trades in this article. If we plot the implied volatility for different strike prices we come up with the skew. There are three main types of skew that markets exhibit: the supply skew, the demand skew and the smile skew.
Supply Skew
The supply skew is defined by higher implied volatility for lower strikes and lower volatility for higher strikes. Supply refers to the natural hedging activity for the major players in the market who have a supply of something they need to hedge. Stock Index and interest rate markets have supply skews. The natural hedge for stockowners is to buy puts in order to protect the value of their “supply” of stock. Stockowners often place “collars” on their positions by purchasing puts and selling calls. This natural action in the marketplace determines the structure of the skew.
Demand Skew
Demand skews have higher implied volatility at higher strikes and lower implied volatility at lower strikes. The natural hedger in demand markets is the end user. They buy calls to protect against higher prices and sell calls to of set the cost of the calls. The “collar” for a demand hedger is to buy calls and sell puts. The grain markets and energy markets are good examples of demand skews.
Smile Skew
The third type of skew is called a smile skew. The smile skew is illustrated by higher implied volatility as you move away from the at the money strike. The at the money strike would have the lowest implied volatility while the strikes moving up and down would have progressively higher implied volatility. The smile skew is generally only observed in the currency markets. The natural hedger has to hedge currency moves in either direction depending of whether they have accounts payable or receivable in the foreign currency.
Defined or Limited Risk Spreads
Call spreads, put spreads and some calendar spreads are defined risk trades. In stock options trading, calendar spreads always have a defined risk. In the futures markets, different contracts in the same underlying month have spread risk. This risk can be substantial and adds an additional dynamic to an option trade.
By selling call spreads, put spreads or both, the trader ends up with a net credit in their account. If the short leg of a credit spread expires worthless, the trade is profitable. In a short call spread example, the trader sells a December corn $2.30 call and buys a $2.40 call. The trader sells the $2.30 call for 6 7/8 cents and pays 4 5/8 cents for the $2.40 call. The net result is a 2 1/4 cents credit less fees. If the corn futures at expiration settle below $2.30, the options all expire worthless and the trader keeps the credit. The maximum risk on this trade is the difference between the strikes of 10 cents ($2.30-$2.40) less the premium collected of 2 1/4 cents or 7 3/4 cents. I can’t speak for you, but risking 7 3/4 cents to make 2 1/4 cents does not appeal to many.
Any trades are educational examples only. They do not include commissions and fees.
The corn call example was chosen to illustrate skew. The corn market has a demand skew which has higher implied volatility at higher strikes. The $2.30 call has an implied volatility of 24.31% and the $2.40 call has an implied volatility of 26.20%. Selling call spreads in a demand-skew market will result in the trader selling the lower implied volatility option and buying the higher implied volatility option. Selling low and buying high is not a good idea in general, and the option business is no exception.
If we look at selling the December corn $2.10-$2.00 put spread the $2.10 put is 4 1/4 cents while the $2.00 put is 1 5/8 cents. The net result for selling the spread is a credit of 2 5/8 cents less fees. The implied volatility for the $2.10 put is 22.43 % while the $2.00 put implied volatility is 21.39%. These examples do a great job of illustrating the effect of skew on spreads. The December corn futures settled at $2.22 1/4, 7 3/4 cents away from the $2.30 call and 12 1/4 cents away from the $2.10 put. A 10-cent move in either direction is about equal statistically, yet the put spread provides a larger credit to the seller and is further away from the underlying price. The call spread is closer to the underlying price and offers a smaller credit. Selling the put spread in a demand skew market allows you to sell the higher implied volatility put option and buy the lower implied volatility option. Selling high and buying low is generally a good thing.
Unlimited Risk Spreads
The unlimited risk spreads we will briefly cover in this article are vertical ratio spreads. To sell these spreads at a credit, the trader would buy the close to the money option and sell at least twice as many further out of the money options. Using the same December corn market, we will buy 1 December $2.30 call at 6 7/8 cents and sell 2 December corn $2.40 calls at 4 5/8 cents. The net result of this trade would be a 2 3/8 cents credit. This trade has unlimited risk to the upside with effect on the trader of being short December corn futures from a price of $2.52 3/8 at expiration. At expiration, the trader will lose money, penny-for-penny, on a move above $2.52 3/8. The maximum profit for the trade would be 12 3/8 cents if we settled at $2.40. The current market price for December corn is $2.22 1/4. The illustrated trade, at expiration, will be profitable if December corn futures are anywhere between zero and $2.52 3/8. If the trader has a bearish outlook, he can be wrong by 30-cents and still have a profitable trade at expiration. This is an unlimited risk trade, and if corn futures were to settle at $3.00, the trader would have a 47 5/8 cent loser.
Any trades are educational examples only. They do not include commissions and fees.
The above examples should illustrate a few basic ideas about skew and how to apply it in your trading. If we stick with the basics of buy low and sell high, it is easy to decide which strategy best fits your objective. The demand skew works against selling call spreads, but works for selling put spreads. The opposite holds true for supply skew situations. In a smile skew market, the skew structure works against selling both call and put spreads. Depending on the trader’s objectives, he or she may enter a vertical ratio call spread and a short put spread in a demand skew market. This may offer a comfortable risk profile, and most importantly, statistically provide the best chance for profitability.
