John,

In following-up on volatility as it relates to credit spreads.

I was looking at VLO, and the volatility smile of its December  options.

The underlying is at $96.20. The call implied volatility looks roughly  like:

100 strike: 37.2%
105 strike  38.3%
110 strike  41.2%
115 strike  51.9%
120 strike  58.6%

I was wondering how you would sell a lower strike and buy a higher strike  
when the vol is lower with the lower strike and higher with the higher strike.  
You had said earlier that with the higher vol. you should get a higher
premium,  but wouldn't that also hold true for the option you were buying, or is this
 offset by the fact that the option being bought is further out of the  money?

Also, if the stock price rises in the situation, and the vol. smile moves  to
the right / upward, and the vol of the option that was sold decreases, won't  
the vol on the option that was bought also decrease?

Thanks,

Jim

Here is a good way to think about it so it makes sense to you.  When
vols go higher, it is implying more volatility in the underlying
correct?  Well, if the stock is going to be volatile, are you going to
want more money for your credit spread?  Of course you will.  Hence the
higher credit.  This is why butterflies are cheap when vols get really
high.  Because there is a higher probability that you will lose money.

Therefore, when there is a sharp call skew, like your example, it is
saying that there is a high probability that the stock is going to go
much higher and therefore cost you money.  So you are being compensated
for this extra risk.

Options make a lot of sense when you can sit down and think about why
they are priced the way that they are.  So in your example, with a
sharp call skew, because you are getting more money for the lower
strike call, that is what is giving you the bigger credit.  The fact
that the call your buying has a higher vol is really not that important
because the option is cheaper (lower delta option).

Now as far as the stock moving higher, yes, both options will increase.
 But the option that you are short is becoming an ATM option which will
trade at the lowest vol.  The OTM call you are long is going to start
catching a bid if there is a sharp skew.  This is not going to stop you
from losing money on the trade as the stock rallies because you are net
short deltas.  What it will do is outperform the same call spread that
has a negative call skew where you are short a low vol call whose vol
is actually increasing as it moves ATM at the same time while the short
deltas are generating losses.  

John

Hey Johnny...  I am invited to your Chi-town get together?  :)

riskarb

Actually, the deltas are closer to 20.  I would be very impressed if
you commuted all the way from Lake Tahoe to make it our meeting.  But
you are more then welcome to come.  We don't have a shuttle service
from O'Hara though.  Maybe Pabst can bring you!

John

Back to the original post....

Admittedly I missed the recent months discussions so if I am jumping in
in the middle and missed the point here I apologize, but in this
example why would we want to sell the cheaper (lower IV option) and buy
the more expensive (higher IV) option?  Seems like the focus here has
perhaps been on the tree and not the forest.  It would make sense to me
to first look at doing this as a debit spread with puts and see which
risk graph looked better.  Without looking I would assume buying an atm
put and selling an otm put would show a much better risk graph and
risk/reward ratio.

It is important when comparing trades on the same idea (in this example
bearish outlook in the underlying) that the focus is on the RISK to
reward and not the cost to reward.  Credit spreads may feel good when
you put them on, but remember you are tying up margin so you never own
the credit anyway.  Someone asked me at the meeting I was at if I
prefer debit or credit spreads.  It was a great question and in my
opinion the correct answer is neither the preference should primarily
be based on the best Risk/Reward (perhaps with the more easily adjusted
trade being the #2 factor).

Hope you all have a happy and prosperous 2006!

Adam B

I couldn't agree with you more.  The original question simply was
focused on skew and not anything else.  I personally think that retail
traders should not pay too much attention to skews because they really
amount to just pennies or maybe a nickel at the expense of much greater
risks.  Of course anytime you can make the skew work for you while
trading in the direction you want, great.

I hate the term credit spreads and I certainly do not endorse the term
or the spread.  The spread is very disingenuous as it implies you are
getting a credit when in reality your post ion is synthetically a debit
spread with its corresponding box.

Risk and cost are two completely separate issues as you pointed out.
Too many times the retail trader is hung up on cost and not risk.  Last
month at our meeting one of the questions on our quiz related to this
issue when I asked the group what was the risk of buy the inside guts
on a strangle.  Many thought the answer was the total debit paid.  This
of course was incorrect because the entire debit was not at risk.  The
only risk was the premium associated with it's corresponding synthetic
strangle.  It was kind of a trick question but it does highlight your
point.

Happy New Year Adam!

John

John & Adam,

Thanks for your insights. My original question was just focused on the  skew,
and not the trade as a whole. The additional emails do help put it in  
perspective.

A general question raised as a result of these emails. When talking about a  
synthetic position, we're looking at the profit/loss graph of two trades that  
look identical. For example, a covered call one the one hand, where a person  
owns the stock & sells a call against it vs. a short put. The short put can  
be considered a synthetic covered call.

When a person is looking at a trade, and knows the  profit/loss, (which would
include the maximum risk), and the margin  requirements, etc., how much does
is choice of which initial trade to make  determined by the type of responses
that are planned out in the event  that a trade goes against the trader?

For example, with a covered call position. if a person has  bought 100 shares
of stock for $50 and they are now worth $50. and sells a  55 call for $3, the
cost basis of the stock is $47. The downside risk is $4,700  if the stock
goes to $0.  

Instead, if a person sells a $50 put for $3 and the stock goes to $0, the  
max risk is still $4,700.

Even though the profit/loss graphs on these two trades are identical,  
wouldn't these trades present the trader with two very different  trades to manage,
and likewise two different paths of responses to take if the  trade started to
go against them? Or does it come down to the personal trading  
preferences/biases of the trader?

Thanks,

Jim

Not only are synthetics the same position, but you really are going to
manage them the same way too.  Let's take your covered call scenario.
Say you are long 1k shares of stock at $50 and short 10 50 strike calls
for 3 bucks.  Your position is the same as being short 10 50 strike
puts for 3 bucks right?  So if the stock drops under either scenario,
one obvious way to hedge the position would be to buy some downside
puts.  Remember, you are short them synthetically.  All you are doing
is buying them back.  If you are long stock/short calls, by buying
puts, you are doing exactly the same thing.  In this case, you are
creating a conversion which is a locked position.  Do you follow this?

So since the positions are identical, so are the hedges that you would
apply to them.  I know it takes a while to get your arms around this
and see this clearly.  Synthetics really have nothing to do with
personal preference or style.  You simply do the one that makes you
more money.  If you can buy the synthetic call for 1.50, why would you
pay 1.65 for the actual call?  If you could sell your long puts
synthetically for 2.50, why would you sell the actual puts for 2.25?
You are just throwing away money.  

John

John,

Yes. thinking through this does make sense. Now I have to walk through it with some real numbers to make sure I understand it fully.

This is definitely a different way to view a trade and also how to respond to how a trade is unfolding. The trading world is a lot bigger than just closing out an existing position if they start to go against you.

Thanks,

Jim

--- not to mention that the synthetic will typically save you not only on the INITIAL margin ( versus the underlying margin) ----- thereby allowing more for intra-day trading etc. etc.----  but at some retail  firms (assuming the clowns don't too botch up the margin on said positions too badly- i.e. pairing errors)  ---- it will/could save you additional on overnight margin as well ---  

  John, am I correct there?

  Murray

  Yes. thinking through this does make sense. Now I have to walk through it with some real numbers to make sure I understand it fully.

  This is definitely a different way to view a trade and also how to respond to how a trade is unfolding. The trading world is a lot bigger than just closing out an existing position if they start to go against you.

  Thanks,

  Jim

Actually synthetics are bad for retail traders because they usually
involve stock which has substantial margin.  Retail traders need to try
to avoid stock as much as possible as it forced them to put up anywhere
from 25% intraday to 50% of the position overnight.  The added benefit
for retail traders are when they already have stock and an option and
they want to get out of their position.  They can do this by creating
the conversion or reversal.  Also the synthetic can help them price
their options better, especially with illiquid options with wide
spreads.

John

  thought a synthetic was =

  long call/short put or short call/long put-- non?

  no underlying involved until it becomes a conversion or reversal... that's what I always thought. So initial (initial) margin is 20% of short side and the long side is paid for by the sale of same. Didn;t think the price of the stock mattered since its all relative.

  Further I always thought you could do 'synthetics' that are not atm but rather are out of the money --- thus margin is even more favorable if you expect a large move-- .  

  what am I missing?  

  M

Actually synthetics are bad for retail traders because they usually
involve stock which has substantial margin. Retail traders need to try
to avoid stock as much as possible as it forced them to put up anywhere
from 25% intraday to 50% of the position overnight. The added benefit
for retail traders are when they already have stock and an option and
they want to get out of their position. They can do this by creating
the conversion or reversal. Also the synthetic can help them price
their options better, especially with illiquid options with wide
spreads.

John

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That is one of the synthetics.  Long call/short put (same strike) is
synthetic long stock.  Yes, in this example, your margin is better then
being long actual stock.  However, there is some risk here with this
position.  If the stock sells off, you are vunerable to having your
short puts excercised in which you will be forced to buy stock.  Not
that big of a deal unless you sized up with the extra margin and now
you can't cover the stock purchase forcing you to have to sell your
stock position at a loss.

Let's review the 6 synthetics here.

Long stock = long call/short put (same strike)
Short stock = long put/short call (same strike)
Long call = long put/long stock
Long put = long call/short stock
Short call = short put/short stock
Short put = short call/long stock

Four of these synthetics will require the retail trader to put up extra
capital for the stock.  The other two expose the trader to excercise
risk.  

John

Thank you

  regards,
  M

That is one of the synthetics. Long call/short put (same strike) is
synthetic long stock. Yes, in this example, your margin is better then
being long actual stock. However, there is some risk here with this
position. If the stock sells off, you are vunerable to having your
short puts excercised in which you will be forced to buy stock. Not
that big of a deal unless you sized up with the extra margin and now
you can't cover the stock purchase forcing you to have to sell your
stock position at a loss.

Let's review the 6 synthetics here.

Long stock = long call/short put (same strike)
Short stock = long put/short call (same strike)
Long call = long put/long stock
Long put = long call/short stock
Short call = short put/short stock
Short put = short call/long stock

Four of these synthetics will require the retail trader to put up extra
capital for the stock. The other two expose the trader to excercise
risk.

John

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