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From Strategy to Practice with Tom Sosnoff Today’S Agenda

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From Strategy to Practice with Tom Sosnoff Today’S Agenda India 2020 From Strategy to Practice with Tom Sosnoff Today’s Agenda Turning Uncertainty and Fear into Opportunity: Making Option Theory & Implied Volatility Tradable Today’s Agenda Understanding IVR Strategies for Different Levels of IV Advanced Portfolio Diversification Extrinsic Premium Overstatement Optimal Deltas for Strategic Probabilities Trade Small / Trade Often Understanding Implied Volatility Rank (IVR) Our objective is to create tradable edge selling premium when it is most expensive. Implied volatility as a stand-alone number does not offer much insight with respect to whether premium is currently expensive relative to itself. IVR places context around how implied volatility is measured compared to the last 52 weeks, letting us know if premium is expensive or not. Understanding Implied Volatility Rank (IVR) Understanding the differences in implied volatility vs. implied volatility rank Implied volatility rank - IV rank simply tells us whether implied volatility is high or low in a specific underlying based on the past year of IV data. For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%. Since all underlyings have unique IV ranges, stating an arbitrary IV number does not help us decide how we should proceed with a strategy. Understanding Implied Volatility Rank (IVR) Understanding the differences in implied volatility vs. implied volatility rank Implied volatility - IV is determined by the current price of option contracts on a particular stock or future. It is represented as a percentage that indicates the annualized expected one standard deviation range for the stock based on the option prices. For example, an IV of 25% on a $200 stock would represent a one standard deviation range of $50 over the next year. Understanding Implied Volatility Rank (IVR) When IVR is inexpensive, premium collected is not sufficient relative to the risk being assumed in a trade. Conversely, when IVR is elevated, premium collected sufficiently compensates us for the trade risk. Understanding Implied Volatility Rank (IVR) Either Debit or Debit Strategies Short Premium Short Premium Strategies 20 30 Understanding Implied Volatility Rank (IVR) IVR SPY 45 Day Periods Between Between Between Between Below 10 Above 50 10 & 20 20 & 30 30 & 40 40 & 50 Average Move in IV +1.2 +0.8 +0.3 -1.4 -4.2 -7.9 (VIX) Strategies for Different Levels of IV Rank Different market environments require different strategies. Strategic decisions are dictated by cost of premium relative to itself. When IVR is elevated (>30) we are premium sellers Low IVR (<20) we lean more on static, horizontal or debit strategies Between 20 - 30 is more of a gray area though we tend to lean more toward selling premium. Strategies for Different Levels of IV Rank Strategy Ideal IV Environment Short Naked Put / Call High Short Put / Call Vertical Spread High Short Strangle / Straddle High Short Iron Condor / Iron Fly High Jade Lizard High Front Ratio Put / Call Spread High Long Put / Call Diagonal Spread Low Long Put / Call Vertical Spread Low Strategies for Different Levels of IV Rank: Low IV Calendar – Buying the back-month option then selling the same front-month option for a debit. Diagonal – Buying an in or at the money back month option and selling a further out of the money front month option. Typically, done with a month between the short and long positions. Put Debit Spread – Buying an in or at the money put and selling a further out of the money put in the same month. Strategies for Different Levels of IV Rank: Low IV Call Debit Spread – Buy an in or at the money call and selling a further out of the money call in the same month. Reverse Jade Lizard – Selling a naked call and a put spread with no risk to the downside. Covered Call – Buy stock and sell an out of the money call. Strategies for Different Levels of IV Rank: High IV Strangles – Selling an out of the money put and call. Straddles – Selling an at the money put and call. Ratio spreads – Buying an at the money put (call) then selling two or more further out of the money puts (calls). Strategies for Different Levels of IV Rank: High IV Butterflies – Buying an at the money put (call), selling two further out of the money puts (calls) and buying an even further out of the money put (call). Essentially a defined risk ratio spread. Jade Lizard – Selling an out of the money put and out of the money call spread with no risk to the upside. Covered Call - Buy stock and sell an out of the money call. Advanced Portfolio Diversification Asset Class Diversification Stocks Futures Strategic Diversification Volatility diversification Time Diversification Advanced Portfolio Diversification: Stocks Correlation among assets gets closer to 1 or -1 as prices fall. Average correlation of gold, bonds, oil, euro, and emerging markets to SPY In late 2008 0.51 In mid 2019 0.33 Advanced Portfolio Diversification: Futures Larger notional products Offer significantly greater capital efficiency Can be segmented into two broad categories Commodities Currencies Advanced Portfolio Diversification: Futures Pairs trading is the use of two correlated products simultaneously. For example: Selling /ES and buying /NQ Benefit of pairs trading is reduced risk and lower volatility of returns. Drawback is there is no cross-product margin relief so both positions must be funded. Advanced Portfolio Diversification: Strategic Diversification Straddle 1 Strangle 0.9 1 Call Spread 0.2 0.0 1 ATM Put 0.3 0.4 -0.7 1 Straddle Strangle Call Spread ATM Put Extrinsic Premium Overstatement Intrinsic premium is the amount by which an option is in the money (ITM). Extrinsic premium represents the market’s perceived potential value of an option based on implied volatility, days until expiration (DTE) and dividends. Because implied volatility tends to overstate realized volatility, extrinsic premium tends to also be overstated. Extrinsic Premium Overstatement Implied volatility Implied volatility represents the market’s expected range for an underlying. Forward looking Realized volatility Is the actual movement in price Backward looking Extrinsic Premium Overstatement Implied Volatility Realized Volatility Extrinsic Premium Overstatement Over the course of the last ten years, we see both 16 and 30 delta strangles overstate actual price moves. This is despite being short calls in a strong bull market. Probability of Expiring ITM at Expiration SPY Strangle Expected Actual 45 DTE 16Δ 32% 25% 30Δ 60% 57% Extrinsic Premium Overstatement A further breakdown shows that although call premium slightly overstated realized volatility, put premium significantly overstated. Probability of Expiring ITM at Expiration SPY 45 DTE Expected Actual Call 16% 20% 16Δ Put 16% 5% Call 30% 45% 30Δ Put 30% 11% Extrinsic Premium Overstatement Because markets are random, we prefer to hedge our risk by not relying too much on directional trades and employ more neutral strategies. Even in a parabolic move higher, short call premium tends to overstate actual price moves and put premium significantly overstates. This suggests a neutral premium selling approach can be successful and even in one-directional markets, our performance is enhanced when we take advantage of premium overstatement for both puts and calls. Optimal Deltas for Strategic Probabilities Where we place our deltas for short premium trades dictates both profit potential and how much time we can expect to be in a trade. Delta placement is also affected by IVR. Although IVR does not change the statistical probabilities of success, it does affect our potential P/L. We want to find a balance between risk assumed and profit potential. Optimal Deltas for Strategic Probabilities The closer we place our trade to ATM (at the money), the longer the duration we will be in the trade. S&P 500 (SPY) Strangles (45 DTE) 2005 to Present 30 Delta 16 Delta 5 Delta Avg. Days to 50% 27 Days 21 Days 17 Days of Max Profit Optimal Deltas for Strategic Probabilities Optimal Deltas for Strategic Probabilities The closer to ATM had the highest P/L while the further out had the highest win rate. S&P 500 (SPY) Strangles (45 DTE) 2005 to Present 30 Delta 16 Delta 5 Delta Win Rate 81% 90% 97% Average P/L $65 $36 $10 Optimal Deltas for Strategic Probabilities When IV was high, we saw a faster turn around on larger profits, but the 5 delta seemed hardly worth it. IV Rank over 50% S&P 500 (SPY) Strangles (45 DTE) 2005 to Present 30 Delta 16 Delta 5 Delta Win Rate 83% 90% 95% Average P/L $85 $38 $5 Avg. Days to 50% 25 Days 19 Days 14 Days Optimal Deltas for Strategic Probabilities IVR does not impact win rates by a noticeable amount. P/L is significantly different for varying levels of IVR. When IVR is higher, we see a much higher average P/L per trade. Strategically placing our deltas and capitalizing on high IVR are key to improving performance. Optimal Deltas for Strategic Probabilities As IVR increases, our P/L increases as well while our success rate stays relatively the same. S&P 500 (SPY) IVR 16Δ - 45 DTE 0 to 25 25 to 50 50 to 75 Above 75 Average P/L $34 $43 $62 $72 Success Rate 84% 77% 79% 77% *1 SD strangle, SPY, 45 DTE since 2005. Managed at 21 DTE. Trade Small / Trade Often In order to create the greatest probabilistic chances for success, we need to create multiple occurrences using both uncorrelated underlyings and diversified strategies. We also want our trade size to reach a balance between being able to move our P/L needle but also not being able to blow up an account.
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