1. Boot Camp Part 2 Option Pit Volatility, Directional Trading, And Spreading

2. Option Pit Boot Camp 1 Quiz What is the flow of model inputs to generate P/L? inputs- position change- greeks – p/l Is acceleration a fair way to describe gamma and what is the market factor most closely associated with it? Yes it is and the factor is realized volatility What is positive Theta? Is it free? Time decay that accrues as dollars and it is not free since there is risk to get it What is Vega in a position? Please explain. Sensitivity to a change in FORWARD VOL. but we use IV

3. You Will Learn What is Low Vol What is High Vol How to Trade vol and direction The Risk Reversal and Sling-Shot Call and Put Spreads The basic butterfly directional trade

4. What is Low IV

5. There is always some nuance to guessing low vs high It takes studying where the reversion levels are – And how far below mean and close to extremes current IV is – How low IV is relative to VIX, VXN, and RVX How has the underlying been moving, relative to vol Has the underlying had MOMENTUM, so ‘HV’ is low but movement his high

6. Low/High IV

7. What is High IV

8. High IV Like low IV high IV is a bit of art and science Where has high been in the stock historically Where is the VIX Is the underlying moving, will it continue to move – Relative to the movement how much ‘slack’ is there in an IV drop

9. IV

10. Skew Because of supply and demand, and the lognormal assumptions, volatility does not have a flat distribution: Options do not move uniformly across the curve

11. Skew

12. Steeper and Flatter

13. What is Steep/Flat Skew When upside calls are priced at a higher IV, and have a real value relative to ATM, skew is steep When downside puts are trading at a higher than normal IV relative to ATM skew is steep Flat is just the opposite, when upside or downside gets smashed. When downside gets really flat, to the point it is about even with ATM, it should be bought

14. Setting up a position to reduce risk Spreads of every flavor!

15. Long Calls Calls should be bought when IV is at extremely low levels The lower the vol the softer the deltas that should be bought (to a point) – Buy ATM when IV is low, but might go lower on a rally – Buy slightly OTM when vol gets disgustingly cheap

16. Long Calls Look for trades where the underlying has been moving but the IV is cheap in comparison Look for MOMENTUM (like I discussed above) It is easy to make money owning calls if one is willing to wait Look to make 25-50% on calls Hope for a GAP up higher for homeruns, don’t got looking to hit it out of the park

17. Long Puts It is easier to buy ATM puts than ATM calls – Because IV rallies on a sell off….usually Put should be bought when IV is at low levels The lower the vol the softer the deltas that should be bought (to a point) – If IV is low but there is some curvature it can make sense to still buy ATM – Skew is much more important in vol selection of long puts

18. Short Puts and Calls When it comes to vol, selling naked calls is an extremely risky bet with serious margin blow up potential Since upside calls get cheaper, it usually makes sense to only sell covered calls or call spreads

19. Puts Sell puts in stock one wants to own, the steeper the skew, the higher the vol, the lower the strike As we stated, look for yield

20. Directional Spreading What about when doesn’t want to buy OR sell an option, what if one is uncertain about IV movement What if one doesn’t want to spend a lot of $$$ This is when the time comes to spread Traders spread for two main reasons: Because they do not want to take a vol position Because they want to lower the cost of the trade and can get the right yield

21. Credit vs Debit There are many traders that prefer ‘credit spreads’ to ‘debit spreads’ Especially in stocks that don’t pay a dividend there is almost no difference between credit and debit spreads In fact, in the money debit spread sometimes have a better pay out than OTM credit spread

22. Credit to Debit If a trader sells an AAPL Sep20 90/95 Put Spread at 1.50 there is a direct relationship to where the 90/95 call spread should be trading (because of synthetics HA I TOLD YOU) Take the Width of the spread minus the credit received to calculate the debit spread

23. Example

24. The Army of Ants It is estimated that the weight of all the ants in the world equals or exceed the weight of all humans This is what retail traders can do in stocks when they sit there and blast ‘credit spreads’ Always take the time to look at the ITM debit They can TRADE for as cheap at a full.10 cheaper on a 5 point vertical, worse on a 10 or 15 pointer

25. In Reality While it doesn’t matter whether one is trading a credit or debit spread, based on trade structure one is still making a decision on buying or selling premium – When the short option is closer to ATM the trade is a premium sale – When the long option is closer to ATM the trade is a premium buy – When it splits the difference it is likely close to premium neutral

26. When to buy Much like a straight buy or sell, buy premium when one expect the stock to move Buy a spread when the risk reward is favorable – If I can get a call spread where the pay out odds are better than the chances of success I am in This will happen when SKEW is in your favor – That means that MOVEMENT is bid over the straddle

27. Using Skews A classic time to buy a spread – NFLX – Curve Is bid

28. Credit Spreads Sell for the same reason that one would sell a put IV is normal or elevated Stock unlikely to drop Looking to pick up income Flatter skew is actually better – Believe it or now skew typically flattens in higher IV situations on the downside

29. Credit Spread The big difference between puts and put spreads or call spreads is that the trader is looking for income, not ownership/selling a security

30. Risk Reward Credit Spread: – Get the right risk reward relative to odds – If the odds of breaking even are 65% you better collect close 35% of the premium – Flat skew Debit Spreads – Good risk reward (same as above)

31. Closing Shoot for 60% the credit or better Do not shoot for more than 75% Close if the credit increases by more the 40- 50% – Or adjust with a fly If one option is worth.05, you might have to just buy the short back

32. Adjusting Spreads If the underlying moves against you, have 1 of two options prepared Have a max loss and kill it Turn it into a directional butterfly I am not a fan of rolling down and increasing size (that is how people blow out) – It is okay to roll down and leave same size on in an attempt to break even

33. Directional Spread Checklist What Is my view of the market What is my view of this stock What is my view of the volatility of the options What is the best spread for that view What is the best strikes for that spread What is my profit target/max loss Do I have an adjustment

34. Advanced Spreads By truly trading a direction AND volatility traders can be wrong and still win Reg-T spreads that use IV AND direction – Modified Risk Reversal – Slingshot Collar – Butterflies

35. Modified Risk Reversal What if one thinks the stock is going higher, but hates paying for stuff What if one hates the idea of owning a stock Sell a put spread OTM Buy a call spread, or calls on a ratio Collect a net credit

36. Standard Risk Reversal

37. RR

38. Modified Risk Reversal

39. Risk Charts: Mod RR

40. Use Use a risk reversal when one wants to take delivery – More income – More risk Use a Modified risk reversal when you think a stock is going higher Don’t want to pay for calls Won’t own the stock

41. Slingshot Collar Named by Charles Cottle Trade allows stock holder to ‘collar a position’ but still have upside on the trade – Trader Buys the Stock – Buys a protective put – Sells a call spread instead of a simple call – Call Spread can be ratio’d to produce a positive theta spread Comes with a cost

42. Sling Shot Standard Ratio

43. Butterfly The Directional butterfly is the perfect spread for a slow moving trade. Allows trader to ‘shoot for a target’ Is SUPER cheap if set up properly Great for the ‘slow play’ Allows for almost NO volatility exposure

44. Example TSLA I think that TSLA is going to be trading between 270-275 by September expiration The IV is not high, but I think its going to drop I want to get paid if the stock creeps higher

45. Example

46. Tips This is good when IV is high and one wants to be a bull Its also good when one has a good feel on movement Set the 1 st long wing at your target price (270) because the stock is going to overshoot You are not trying to collect all the premium – If you can return 100% that is a huge win

47. Summary We have even more coming Volatility is the key to all trades in options Credit and Debit spreads are the same Risk reversals and modified reversal serve different purposes Flies are cool

48. Boot Camp Quiz 2 Explain what realized volatility is? What does low IV mean? What is the chief advantage of a spread? Is there a low IV type of trade?

49. Thanks! For question you can contact: mark@optionpit.com andrew@optionpit.com 1(888) Trade-01