When the market is slowly retracing higher from a bottom and VIX is still elevated, you'll make way more money selling high IV OTM calls and hedging them delta neutral, than buying the same OTM calls naked.
When the market tanks and they blow up vol,along with the skew inverting,it's the closest thing to free money you will find.. P.s.. Im talking about the upside skew
Although you would have gotten killed selling hedged OTM calls on the way down trying to pick the top in vol/market bottom back in March. I probably would have sold some when VIX hit 50, then more at 60, stopped out at 70, then reloaded at the 80 VIX level and prayed that VIX wouldn't go to 100. I would have had to underhedge the call sales to have made any money. Easier said than done.
Here are the IV for the 5 delta 1 year and 25 delta 1 year from our options API: Especially the way OTM have fallen sharply. To your question do traders think the market will fall: here's a graph of the 50 delta / 25 delta 1 year IV: The third graph from the bottom shows this ratio. As the market fell, the ratio of the 50 / 25 delta rose. Then, right at the bottom the ratio fell sharply.When the ratio started rising, so did the market. I don't see evidence that traders think that the relationship between the 25 and 50 delta shows that the market is more likely to fall.
@Matt_ORATS, the reason why you see the ratio between the volatilities wider during the selloff is that vols go up and thus deltas will be further apart in the strike space. If you want to look at the skew dynamics using volatilities at specific deltas, you should normalize them for the overall level of volatility. For example, you don’t want to look at 25d put - 25d call, but rather look at (25d put - 25d call)/50d.
Did you play that at all this time around? Mid-march you had Dec 3000/3400 strikes trade less than a vol apart.
So this clearly shows that the OTM 25 delta call IVs blew up much more than the rest of the smile when we crashed in March...albeit they probably started at incredibly depressed IV levels vs the ATM when were close to the market top in mid Feb. When we crashed last month the SPX curve flattened dramatically. OTM Call IVs far outperformed same delta OTM Put IVs, which most traders don't realize. So buying single-digit IV OTM calls and hedging them before a crash is as good or better than buying the steeper IV OTM puts. Only problem is that on the crash you move so far away from your long OTM calls that their vegas are too small for you to really hit the homerun....most of the money is made on the gamma. Selling 1X 2s (sell 1 ATM vs buy 2 25 delta calls) would have been the way to go when the SPX peaked in mid-Feb. On the way down, your 1 x 2 would have killed it as the OTM IV call skew exploded vs the rest of the curve. Obviously on the way up you want to have the opposite. Now, the IVs of those OTM SPX calls are imploding because no one wants to own the upside strikes where the SPX is probably going, which will be the worst strikes to own when the VIX crashes back below 20.
You probably mean your 1x2 would have killed you, right? Short gamma would have been the main source of PnL. Because of the negative dVega/dSpot, your Vega gains would be a mere afterthought, in fact you would have probably net LOST money on both gamma and Vega, depending on the maturity.
You would have been long gamma starting out. The 2 lower IV OTM 25 delta calls are more gamma rich than the higher IV ATM. That's called skew theta. On the way down you probably would have been slightly long to flat gamma. And you would have been long vega the whole way down. Further OTM calls have more volga/vomma (vega convexity) than ATMs (which have zero vomma). That's a homerun trade that would have landed you at the Ferrari dealership.
Using ratios like 50/25 IS normalization. Ratio-ing different delta points of the vol curve to the ATM or 50 delta point is industry standard. Your argument about the ratio between 2 delta points doesn't make any sense. Vol can go to the moon and the IV ratio can SHRINK between the 25 delta point and the ATM point...like what happened with the 25 delta put IV and the ATM IV during the break. Any IV ratio does NOT have to widen during the selloff or when vol goes up. The 50 Delta/25 Delta Call IV ratio widened because the skew flattened between the two delta points when we broke, NOT because the "deltas are further apart in strike space."