1. Volatility: The Option Pit Method Option Pit
Using Volatility to Trade Direction
Single Options, Spreads, Fly’s
Option Pit

2. What You Will Learn Value of Mean Reversion buy/sell option decisions
What are hard and soft deltas
Trading Credit and Debit spreads
Trading Directional Butterflies and Broken wing flies

3. Implied Volatility
Q: What makes trading volatility different than trading a stock?
A: Over the long term we know where implied volatility of a stock or index is going to go. We do not know where the stock price is going to go
IV mean reverts

4. AAPL Stock
Is there a Mean?
No: look at the 50 and 200 DMA

5. AAPL IV
Is there a mean?
Yes!!!!

6. Mean Reversion A stock price can go anywhere and stay there
While volatility can GO anywhere, it cannot stay anywhere
It must revert to its mean overtime
Understanding this can help with buy and sell decisions

7. Getting Long When one wants to go long one can
Sell puts
Buy calls
Despite what you have been told, there are perfectly acceptable times to do both

8. Short Puts A short put is Long Delta and Short Vega
Thus the trader is hoping the stock moves higher, and the IV comes in
What makes IV drop?

9. Short Puts IV often drops, because HV drops
Thus a short put is actually a play on lower realized volatility
When selling a put, the trader is really betting that the underlying WON’T GO DOWN

10. GLD

11. Long Calls A long call is long delta and long vega
The trader is hoping that IV goes up and vol goes up
What makes that happen?

12. Long Call
We are actually hoping that the stock is going to go up, not simply creep higher
We want upward movement and an uptick in realized volatility
We are betting the stock is GOING TO GO UP

13. AAPL

14. Getting Short
Like going long, when one is making buy/sell option decisions, one must take IV into account
When IV is high and one thinks the stock is going to go down: sell calls
When IV is low and one thinks the stock is going to fall: buy puts

15. Short Calls: AAPL

16. Buying Put: IBM

17. What Is Delta
Delta has several definitions. However, the one most commonly used is the correlation of an option to its underlying.
Thus an options with a positive .60 delta will make .60 for every dollar the underlying rallies
It will lose .60 for every dollar the underlying falls

18. Deltas Hard Deltas Soft Deltas
A hard delta is relatively resistant to a change in volatility
Soft Deltas
A soft delta is relatively sensitive to a change in volatility
Understanding the difference can help with strike selection

19. Hard Deltas When would one want hard deltas?
When one isn’t sure of IV future movement
When IV is very high
When one isn’t sure of the severity of the expected move but wants to have limited risk

20. AAPL

21. AAPL
Dec 5 Dec 6

22. The Math 12/5 12/6 Sell 3 AAPL Dec 545 puts at 4.90
Buy 1 AAPL Dec 565 put for 10.50
Total Outlay: $1050
Total Delta: -43
12/6
Sell 1 AAPL Dec 565 put at 13.50
Cash Received: 1350
Profit:
Buy 3 AAPL Dec 545 puts for 3.80
Total Outlay: $1140
Total Delta: -75
Sell 3 AAPL Dec 545 puts at 4.90
Cash Received: 1470
Profit:

23. Keys to Hard Delta
Hard delta is a time that the trader wants to take vol out of the equation
Trader is under the assumption that vol is going to drop
Make sure to recognize when one is taking on TOO much delta
Make sure to do the math on how much delta one is getting for the cost, and how that will change when IV drops

24. Soft Deltas
As soft deltas are more sensitive to IV changes, and there are some very specific times where they can make a lot of sense
IV is really low
We are expecting a major move
We want to make a cheap bet

25. PNRA

26. PNRA
11/19
11/22

27. The Math 11/19 11/23 Sell 3 PNRA Dec 175 calls at 6.40
Buy 1 PNRA Dec 165 call for 9.00
Total Outlay: $900.00
Total Delta: 75
11/23
Sell 1 PNRA 165 call at 15.00
Cash Received: 1500
Profit:
Buy 3 PNRA Dec 175 calls for 2.85
Total Outlay: $855.00
Total Delta: 120
Sell 3 PNRA Dec 175 calls at 6.40
Cash Received:
Profit:

28. Soft Delta
The key to a good soft delta trade is to believe that IV wont drop on a move.
If one is relatively certain IV will remain stable then cheap options and cheap deltas will out perform in the money or even ATM options
Obviously be wary of going ‘too soft’

29. XYZ
Q: XYZ stock is at a near all time low in IV terms, at the same time the stock is peaking out and realized Vol is increasing
The Trader wants to get short delta in what order would the trader choose to get short
Sell An ITM Call that has a 75 delta
Sell an 3 OTM Calls that are each 25 delta
Buy 1 ITM put that is 75 delta
Buy 3 OTM Puts that are each 25 delta

30. Directional Spreading
In the above scenario, believe it or not there are times where none of the answers are truly the best answer
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 the cost of the trade and can get the right yield

31. 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 spreads
EXAMPL AAPL DEC 560/550

32. 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

33. 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

34. Using Skews
A classic time to buy a spread
AAPL
Curve
Is bid

35. AAPL Call Spread AAPL closed just above 560
Odds are about 3 to 1 on something that has 50/50 odds of ending up in the money

36. Sell a Spread
Again, like selling a straight option the best time to get short premium is when one expect the underlying NOT to move in a direction
If IV is elevated but COULD go higher
Try to get SKEW in your favor
This will increase risk reward
Get risk reward as favorable as possible

37. Risk Reward
Unlike a debit spread risk reward will likely NOT be 50/50 on its surface
But, unlike a debit spread one does not need movement to happen
ONE wants movement NOT to happen
Using SKEW can help maximize return
For a PUT SPREAD: a tighter spread with more contracts will outperform WIDER and FEWER contract

38. GOOG

39. GOOG
5 pointer
10 Pointer

40. Target In general always try to make more than you are losing
Shoot for 50% of premium collected
Try to hold losses to 30% of premium collect
Take never lose more than 50% of premium

41. Directional Butterflies
Directional butterflies are an extremely inexpensive way to trade on direction
They are great for expensive names
‘momo’ plays
In using butterflies trader tries to pick where momentum will end
Low risk high reward trades

42. Mistakes
Putting on the fly is easy, choosing when to take it off is the key
Many traders get ‘greedy’ with directional flies because they see how much premium can be made if the underlying ‘parks’
Because of the risk/reward I am usually happy with 20% after commission

43. Keys to Success Execute when IV is elevated
When SKEW in the direction of the trade is ‘flat’
Target should be about 1 week
Set the wing closest to the underlying price at the level the trader expects the stock to hit
NOT THE THORAX
Will prevent ‘over shooting’
You will be surprised how well the fly does at the wing

44. Notice P&L at Wing

45. Broken Wing Butterflies
Broken wing butterflies are a retail trader’s way of trading a ‘front spread’
At onset delta will be opposite of the direction the trader wants the underlying to move
As time passes trade pick up a lot of delta
Trader expect IV to be stable and fall
Trader is trying to trade skew and volatility
One wants traders to see skew fall and vol fall

46. Keys to Success Try to get a credit on the spread
Set a time frame of 10 days or so
Set the long at the target price
Will avoid overshooting
SKEW SKEW SKEW
Well structured a BWB will win regardless of the movement in the stock

47. AAPL On ‘track the trade’ I walked through an AAPL butterfly
SKEW was ‘JACKED UP’ as traders were running IV and SKEW up: Thursday Morning

48. Today AAPL moved in the opposite direction of my spread
But IV and SKEW moved in my favor
Now I am up on 3 spreads!

49. Summary Belief in mean reversion is key
When IV is high, we sell it, use harder deltas
When IV is low, we buy it, use softer deltas
Spreads are just like naked options
Butterfly trades are for cheap bets
Vol and Skew is the key to successful spreading

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@optionpit

51. Thank You For Attending Question?