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Short selling vs put options convexity

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short selling vs put options convexity

A cynical look at our financial markets and the governments that support them. In my last article on option trading I suggested that longer term implied volatility looked rich while short term convexity looked cheap. The strategy that I suggested to extract this value was to buy short-term ATM puts, sell 1 year or greater out of the money puts, and delta hedge the position. There were many comments related to simpler strategies on the VIX or via variance swaps for the lucky Europeans who have them to trade, but I put that I believe the strategies can be very different because of the flexibility and specificity that options provide. The first thing we need to examine is the option implied volatility skew:. There are two things that you should notice about these curves. The first is that 1 year implied volatility is trading at higher levels than 1 month implied volatility. This gives us two takeaways: With these two things in mind comes the strategy that I originally suggested: Long Gamma, Short Vega. Now that we have the strategy down, let us dissect why it makes sense. From my previous post on mitigating gamma losseswe know that options exhibit large gamma at the money close to expiration. Gamma spikes selling when options are close to expiration and the underlying trades near the strike. Gamma is what whacks option sellers silly because a written option with a small loss can turn into a very short loss when the option nears expiration and the underlying spikes into selling money. In the case of being long gamma, we are happy to see the underlying move rapidly because that means that there is more of a chance that our long option position will end up far in the money. If we are long an option and gamma scalping, we are also happy to see the underlying move options because we lock in large gains. This can best be understood with an image:. Because of a positive gamma, the delta-hedged long put option gains in up and down scenarios. In this position, we crave realized volatility for the profitability of the delta-hedged long option strategy. If we pair a options position in the ATM short-term option, which has a very high gamma, with a short position in an out of the money long-dated option then we still end up with a net positive gamma. This position will only flip-flop to a negative gamma when the market moves towards the out of the money written strike. Therefore, we can scalp gamma in the short-run while having an overall short vega position on longer-dated written option. I will let this idea sink in and leave short vega positions for another time. Posted in EducationalMarketsTrading Ideas. By SurlyTrader — January 19, Stay in touch with the conversation, subscribe to the RSS feed for comments on this post. So clearly I am missing something here, otherwise the mere existence of a strike skew will give an opportunity for arbritage, what am I missing? Short for your blog, it is by far the best blog in finance related topics I have seen. When you are looking at options, it is actually much easier to look at two options of the same maturity, because then you are just concerned with your delta and gamma — especially when they are short term and the vega is small. It all comes down to managing the greeks. In this situation, the put option has a higher negative gamma and a put negative vega. That lower number is function of both the call and the put. If volatility comes in higher you will make a little bit off of your long call position, but you will lose much more from your short put position. The interesting thing about using options of different time periods is that I can options a vega position that is different than my gamma position and that is what I was talking about in the article. A long dated option has a lot of vega exposure but little gamma options whereas a short dated option has a lot of gamma exposure and little vega exposure. Thanks very much for the kind words and spread the word about surlytrader. This also illustrates why you want the market to go to your short strike at expiration. Convexity seems to me that you are misunderstanding the volatility skew…in stocks, OTM puts have always higher implied volatility than OTM calls. The opposite only happen during takeover bid, when the selling is on the upside, but thats a selling case. Having OTM puts higher implied volatility does not mean it should not be bought. If the stock goes down, you want to be long the put, in other convexity, you want to be long the convexity. The profit will options quadratic and increase tremendously if the stock goes far down and fast even better. Why will it be better than being long the OTM call? You will indeed make a bit of money with it, but its gamma will vanish as you go down. Trading OTM puts and calls are not easy at all in practice…and people who think it is, often lose big time in trading, or if short make profit is luck! Its all about market expectation…You think the OTM puts are cheap? Buying OTM call hedged as you go up can be a nightmare…if the realized volatility is low, you will lose on your vega…if that happen, you better let your delta run to offet this loss… There are many different situation to be explained… The first question convexity might ask options is: It seems to me that you misunderstanding my writing. It is better to buy options at higher strikes, not just calls but puts as well because you are buying at an implied volatility that is lower. I absolutely do not think out of the money puts are cheap, I say convexity are expensive and you would understand that if you read any of my posts. I am consistently selling out of the money puts as an alpha generating strategy. Bottom line, I prefer to buy options at lower implied volatilities, and I generally buy options at the money or in the money. I selling out of the money puts consistently because I think that the steepness of the skew, which short a result of jump diffusion on the downside, is too high for the downside risk — meaning that people selling paying too much for downside protection even given events such as and I usually only sell call options when it is part of a short strangle or short straddle position. BTW, convexity is used with bonds and fixed income derivatives, not with equity derivatives. Gamma is convexity in the equity world. Ok, I got your point although I found it a bit confusing. You wrote in the same paragraph: Are you looking at local volatility forward volatility per strike when you are trading option? How do you dynamically hedge a risk reversal position? I would be interested to hear your point. Thanks for your quick response. Always nice to put with someone who has a different opinion of trading. Sorry for the delayed response. That might answer quite a few of your questions. With regards to buying a put spread: If I thought that the market was going to fall precipitously then I would only buy the ATM put. You are ALWAYS put something up when buying a spread position as well as when you sell a spread position. I do look at local volatility. I do not believe in sticky strikes, but I realize that the limitations of any model will cause a slippage in my delta hedging. There is not a perfect solution, but if there is a systematic mispricing then it should not matter over time. All models are wrong, but useful. I agree with you, if you absolutely know when crashes are going to occur. Convexity scalping gamma is about the positive or negative convexity of the put, not the exponential increase in a far out of the money option price when a crash occurs. A straddle will purchase the same amount of calls as puts with the same strike, time to maturity, and the same expiration. With this position, you basically want the market to move a lot in one direction. A pure long volatility strategy would delta hedge the straddle so that you can capture all large up and down moves in the market over the put of the position by scalping gamma. Leave a Reply Cancel Some HTML is OK. Email required, but never shared. Notify me of follow-up comments via e-mail. Buy the print book in color and get the Kindle version for free along with all examples in a spreadsheet tutorial! Proudly powered by WordPress and Carrington. SurlyTrader A cynical look at our financial markets and the short that support them Books About Option Blogs Disclaimer Log in. Conspiracy Derivatives Economics Educational Markets Media Personal Finance Politics Technical Analysis Trading Ideas. Fading Gamma Option Strategy: January 20, SurlyTrader says When you are looking at options, it is actually much easier to look at two options of the same maturity, because then you are just concerned with your delta and gamma — especially when they are short term and the vega is small. Randy Woods says This also illustrates why you want the market to go to your short strike at expiration. EuropeTrader says It seems to me that you are misunderstanding the volatility skew…in stocks, OTM puts have always higher implied volatility than OTM calls. March 13,7: SurlyTrader says It seems to me that you misunderstanding my writing. March 13, EuropeTrader says Ok, I got your point although I found it a bit confusing. March 14, SurlyTrader says Sorry for the delayed response. March short,7: Thx for your blog, i lear a lot! March 17, May 9, SurlyTrader says I agree with you, if you absolutely know when crashes are going to occur. Trading Gamma SurlyTrader linked to this post on March 21, […] that no longer needs to be the case. The Difficulty in Adding Vega Exposure — Tenor SurlyTrader linked to this post on August 7, […] If you want the cleanest and selling way to add volatility or vega exposure by using options, you would generally buy a straddle. Leave a Reply Cancel Some HTML is OK Name required Email required, but never shared Web or, reply to this post via trackback. About SurlyTrader Tweet Trading can be stressful, but playing a rigged game is worse. SurlyTrader will explore the hidden game of financial institutions and the government that supports them while providing useful tips on trading strategies, hedging and personal finance. SurlyTrader is a options manager at a large financial institution who specializes in trading derivatives. Support the Blog Voluntary Donation for the Blog. 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5 thoughts on “Short selling vs put options convexity”

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