Options on leveraged ETFs

Discussion in 'Options' started by ruok, Jun 8, 2010.

  1. ruok

    ruok

    I've been noticing that implied volatility for leveraged ETFs are higher than they should be based on implied volatility for their non-leveraged counterparts (e.g. IV on a Dow ETF might be 20%, while IV on a 2X leveraged Dow ETF might be 50%. Theoretically IV on the 2X leveraged ETF should be 20%*2=40%). I've been thinking of buying volatility on the non-leveraged ETF and selling volatility on the leveraged ETF. Is this a feasible strategy?
     
  2. sambian

    sambian

    You are right. But theoretically IV on all strike prices for the same expiration date should be the same, and this is not the case, therefore we have the "volatility skew".

    For me this is as feasible as "buying" and "selling" volatility from the skew.

    Your question is interesting so it would be nice if there is a discussion about it. I would like to ask you how do you plan to buy and sell volatility? For me this is impossible. I know that many people believe that they are "buying" and "selling" volatility, but I don't understand how they do it. So can you describe more about your plan - for example do you think about just buying and selling ATM options, or do you plan some kind of "delta hedging" or something else?
     
  3. ruok

    ruok

    yep, i would be delta hedged on each leg, so it would be 4 trades (i.e. buy non-leveraged options, sell non-leveraged ETF to delta hedge, sell leveraged etf options, buy leveraged ETF).
     
  4. If the IVs were off by enough, maybe something like this would be possible? (and it would only require 2 trades - of course to sell the calls you would need a large account, etc.)

    Pretend XYZ is an index and UXYZ is the 200% fund.

    If XYZ=30 and UXYZ = 60

    XYZ 35 call for 3 monts = $300

    UXYZ 70 Call for 3 months = $700

    Sell 1 UXYZ call - buy 2 XYZ calls - collect $100

    If they stay below the strikes, you keep the $100. If they go above the strikes, if the UXYZ tracked properly, you should be covered.

    For example, if XYZ = 40, UXYZ = 80 at expiration

    Long XYZ calls = $1000
    Short UXYZ calls = $1000

    Profit would still be $100.

    You could also do it on the put side at the same time.

    Problems include the fact that the short calls/puts aren't considered for margin purposes covered by the other calls/puts (different ETF), potential slippage, etc. Also potential tracking error by the 2X ETF.

    ruok, one good way to check on an idea you have is to check historic option prices at www.crimsonmind.com. Just go back to a date a few months ago, get the prices and the option prices and see how the trade would have went.

    JJacksET4
     
  5. sambian

    sambian

    So in theory your trades should be profitable. I would never do them, because for me the theory behind the option pricing formulas is completely wrong. But I have to be very theoretical to explain why.
    Without being theoretical, I can point you one empirical fact - the existence of "volatility skew". If the theory about option price depending only on future volatility was right, the skew wouldn't exist. And delta hedging would be possible only if the theory is right.
     
  6. It might be if the two underlyings tracked each other at a fairly consistent 2:1 ratio but 2X leveraged funds tend not to do this.

    As JJacks suggested, it's a good idea to model past performance using historrical data to see how this would have performed under various market conditions,