Andy, A few observations. For the more experienced, please correct me. 1. Maximun pain theory is an exit strategy where you exit only when the pain is at its maximum. IOW, you have no exit plan, only pain to tell you when to get out. 2. Your comment about buying when vol is low, and selling when high. Buy cheap and sell expensive, right? You read about this in the textbooks. MM are not dumb. There is a reason why the vol is where it is at. Hi vol means something is ==happening == 50 point drop in a couple days, that sort of thing. Do you really want to sell into that sort of market? The basic rule is high leads to high, and low leads to low. Some traders have a rule only to sell when the market is quiet, low to moderate vol. Or, at least, to lower their position size, and very strict risk control. And buy..... well, just don't unless you're good at predicting market movement. Someone please correct me if I have have it wrong.
Andy, I'm not sure I'd agree with your statement. When implied volatility is low, option prices are relatively inexpensive. All other things being equal, you want to be a net buyer of option premium. If IV rises, and all else remains constant, you will see an increase in the value of the option you purchased. However, a vertical debit spread involves both the purchase and the sale of options. An increase in the IV of the long option tends to be offset by the increase in the IV of the short option. Conversely, a drop in the value of your long option due to falling implied volatilities tends to be offset by the decreased value of the short option. When IV is low, you will generally want to simply buy calls or puts because concerns about a drop in IV are less acute due to the existing low levels. Should IV return to the mean, i.e., rise, then you should experience an appreciation of your long option assuming all else remains the same. When a possible drop in the volatilities is a concern, a vertical debit spread is one possible directional play because the short option hedges against the fall in IV. As a practical example, consider the current market. It has fallen considerably and IV has risen as a result. Perhaps you anticipate a "bounce" or counter trend rally. Buying call options is problematic. Even if you are correct and we see the market trade higher, chances are that IV will fall and erode the value of your long call, thereby depriving you of some or all of the profits that you might otherwise have expected to receive with that directional move. You can offset that IV risk by selling a higher strike call. You now have a spread, consisting of both a long call and a short call. As IV falls the losses in your long call will tend to be largely offset by the profits in your short call. The same is true with credit spreads, i.e., the rich volatility you sell in your short option is offset by the higher volatility in your long covering option. When IV returns to the mean, the profits you experience from the depreciation of your short option will be largely swallowed by the losses in the long option. This reply is getting a bit long winded, so I hope it is making sense. -Chris
I am looking at something new for me == a double diagonal position. B Aug 1330 call S Jul 1300 B Aug 1150 put S Jul 1180 requires about a 75 (futures points) debit. I ran the numbers and looks like a fairly wide profit zone. What am I missing? I havwe heard of a single diagonal, but not a double.
The Maximum Pain strike is the strike at which the net value of all puts and calls for that month would be minimized, if the underlying closed at exactly that value on expiration day. Check out this web site for more information and graphs: http://www.ez-pnf.com/maxpain.htm
Please help me understand why I am in maximum pain when the options expire worthless, when I have a net short position. Perhaps I am missing the pain of success.
>How do you plan to deal with a drop in IV? What if it drops to 14% within a week? I still have a break even of 40 down and 50 up from today's price. Market movement still rules. AS I understand high IV tends to hang around for awhile and I do not expect much below 14 for awhile. Thanks for the heads up, though. I will have to watch the premium movement as well as price movement.
Your break evens will change with a change in IV. Double diagonals are rather sensitive to the effects of implied volatility. An increase in IV will boost the value of your long options, while theta erodes the value of your short contracts. That's the good news. The more problematic situation occurs when IV is relatively high and then falls. In that case, the value of your long option contracts drops. Your break even points begin moving closer together and in extreme cases will disappear, leaving you with a trade that is a guaranteed loss. Not that I have ever had this happen to me or anything. Let's just say I learned about the concept of IV crush in a very demonstrative way. Watch the IV. A drop can hurt you on these positions. Good luck with it! -Chris
Thanks, Chris. I really like the relative small 20 point difference in strike prices and some good support and resistence at those levels. Very tempting.