Option Traders - How to Profit from this Market Exactly, Buying Volatility and Selling Skew
Date Published: 2018-12-12
DisclaimerThe results here are provided for general informational purposes, as a convenience to the readers. The materials are not a substitute for obtaining professional advice from a qualified person, firm or corporation.
LedeSkew and volatility make a perfect match right now in this market -- buying low and selling high is the mantra for all of trading, even with volatility. Now see it in action.
PrefaceWe have published several insights over the last two months surrounding market volatility and how it has become a unique opportunity for option traders. We then demonstrated the importance of option skew -- an odd sounding term which is in fact very easy to understand and critically important to successful option trading.
Today we take both ideas, and combine them into a custom back-test that buys the depressed volatility and sells the elevated skew to create a direction less option strategy that has seen massive returns since October of 2018, and over the last two-years.
The Short-term Option Volatility Trade in Coherent
Here is the skew for ADBE and SHOP, respectively. This data is provided by CBOE Livevol.
The skew shape is in fact normal, with the lower strike prices (out of the money puts) showing higher volatility than the at the money strikes. What is a bit abnormal is how pronounced that slope to the downside has become.
What we want to do is back-test owning the the at-the-money-options (both calls and puts) to create a straddle. This position benefits from large stock moves in any direction, which is the market we face right now. Then we want to add to that test, selling a put that is up on that skew slope. This is the very definition of buying low and selling high.
The result of this long straddle and short put reduces the cost of a naked long straddle, meaning the stock has to move less for the overall position to be profitable.
We will examine the outcome of going long a short-term at-the-money (50 delta) straddle, in options that are the closest to 7-days from expiration. But we have a rule -- it's a stop and a limit of 20%, and, we back-test re-opening the position immediately, as opposed to waiting for 7-days later.
Let's not worry about stock direction or earnings, let's try to find a back-test that benefits from volatility. Here is the custom strategy in Trade Machine®
That's long an at-the-money (50 delta) straddle and short one out-of-the-money (15 delta) put.
Second, we set a very specific type of stop and limit:
At the end of each day, the back-tester checks to see if the long straddle is up 10% or down 20%. If it is, it closes the position, and re-opens at the same time, another long straddle, but this one now re-adjusted for what is the newest at-the-money strike price.
The plain English explanation of setting a looser stop loss (20%) to the limit gain (10%) is as follows: "If it didn't work today, we'll see if it will work tomorrow." That has been a steady dose of winning back-tests in this market. If one-day is calm, there's a good chance, soon enough, a volatile day will follow.
We have a full blown tutorial write up on this type of stop/limit behavior in the Discover Tab: Stops & Limits Roll Timing What does "open again at normal time" vs "immediately" mean?
We back-tested this only over the last nine-weeks. We are hyper focusing not on a long drawn out pattern, but rather this time, right now, this period of volatility.
And now we look at the last two-years, but excluding the nine weeks above. So, we are looking at 2016-12-12 through 2018-10-01:
The mechanics of the TradeMachine® Stock Option Backtester are that it uses end of day prices for every back-test entry and exit (every trigger).
Take well bounded risk, small, and direction-less, and let a tweet, a news headline, an Apple headline, a day of pessimism or a day of optimism, whatever -- move the market, as it has so often in this new volatility regime. Then sell higher priced volatility offset the cost of that initial position.
WHAT HAPPENEDThis is how people profit from the option market, its empirical testing, not luck. Trade Machine gives you the capacity to trade beyond luck. Can you imagine the other custom strategies we test?
Tap here to see it for yourself
You should read the Characteristics and Risks of Standardized Options.
Past performance is not an indication of future results.
Trading futures and options involves the risk of loss. Please consider carefully whether futures or options are appropriate to your financial situation. Only risk capital should be used when trading futures or options. Investors could lose more than their initial investment.
Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition.
Please note that the executions and other statistics in this article are hypothetical, and do not reflect the impact, if any, of certain market factors such as liquidity and slippage.