I promised in another thread to post what in my opinion is the number 1 most direct and precise factor driving the skew in S&P500 options. Here it is. If I could buy OTM puts and sell OTM calls at the same volatility, I would make money day in and day out, virtually risk-free, with a ferocity and consistency the world has never known. I would quickly become the richest man in Babylon. I would be so rich I would fly all of you to Chicago and buy you a drink - even beep1 if he promises to behave himself. How would I do that? I've mentioned before that when the S&P rises, the VIX drops and when the S&P drops, the VIX rises. That is true in every time frame - tick by tick, minute by minute, hour by hour, day by day. I've posted charts proving that point before, and would be happy to do so again. It's the most consistent phenomenon in all of trading - at least I can't think of a more consistent one. So if the futures were 1200 and I could buy 1100 puts at say 20% volatility and sell 1300 calls at 20% volatility - and buy futures so I'm delta-neutral - It would be almost impossible to lose money. When the futures go up, I would become short vegas. What do you want to happen when you're short vegas? You want it to go down, and that's what would happen. Money in my pocket. I would buy premium cheap and become premium neutral again. If futures went up more, I would again become short premium (including short vegas) and volatility would drop further. More money in the dmo account. I would again buy premium and become premium neutral. If futures went down, I would become long premium and volatility would go up. Still more dough in my pocket. I would sell the expensive premium until I was again premium neutral and await the next move, which again would only make me money. And if ever there was a crash? My god - I would become so rich that Rupert Murdoch would become suicidal with jealousy. But Mr. Market just hates when that happens. He can't stand it when making money becomes easy. So he prices the otm puts just high enough and the otm calls just low enough that it neutralizes the profits you would make from this play.
A conversion is when you buy puts and sell calls at the same strike (and buy the underlying). This is buying and selling two strikes far apart - completely different.
to condense let see if I understand you. sell OTM calls buy OTM puts 1.moving up buy more OTM puts 2.moving up more sell more OTM calls 3.moving down again buy back OTM calls So simple!!!!
My point is that this would work IF there was no skew, IF every strike traded at the same IV. Because of the potential for that play, the lower below-the-money strikes are much more valuable than the higher above-the-money strikes. Because the lower strikes are more valuable, they trade at a premium (higher IV) than the above-the-money strikes. Hence the skew. The market being fairly efficient, the higher price of the lower strikes approximately counterbalances the money that would otherwise be available with this play. The existence of the skew effectively eliminates the play.
brilliant thoughts. you have my best respects, and i hope you accept them. if you do not, it is fine, you still have my respects as you have earned them now back to the skew. the only missing piece to put the last nail in this coffin, is to explain why vol is expected to rise when spx goes down? note that your explanation is valid (with extension) to commodities as well (just switch things upside down, and replace put by calls, sell by buy). in the case of commodities, the last question then becomes: why prices are expected to go up faster than they go down? i have my answer to this question, and will provide it later. it relates to how sellers of vol hedge and the relative ease of going short or long in stocks/cash/commodities. (things are asymetrical). PS: you deserve to be rich dmo. you have it in your mind (the most difficult part is there).
I'm glad you got it beep - thanks for taking the time and trouble to read carefully and work through it. I was beginning to think I'd gone a little too far without laying enough foundation. Perhaps it's not immediately obvious that if you're long 1100's and short 1300's, then as the futures move up toward 1300 you get shorter and shorter premium - and vice versa as the futures move down toward 1100. The truth is I stumbled upon all this through direct experience around 1984-85 - when people blindly trusted their pricing models and all strikes in the T-bond options (except the ATM's) traded "flat," or at the same IV. A friend of mine and I noticed that when we were long OTM puts and short OTM calls, our accounts just seemed to grow magically. We couldn't figure it out. Finally we realized what was going on. Every time the T-bonds went down, IV went up - and conveniently, we were long vegas! Every time the bonds went up, IV went down - and lo and behold, we were short vegas! It was really too good to be true. And it didn't last long - maybe a few months from the time we realized what was going on and how to play it. The market figured it out, the skew was born, and the golden-egg-laying goose stopped producing. So why does IV go up when the futures go down and vice-versa? I think the rock-bottom basis is again that the world is long stock, so every time the market ticks down, nervousness ticks up - so there's a little more buying of insurance in the form of puts. Every time the market ticks up, nervousness ticks down, and there's a corresponding decrease in the buying of options.
So it is your opinion that the skew exists so that bear risk reversals are not profitable? Are you for real?
It's sounds really nice. Why don't you price a real time example ? We will see which options you trade and how they vary, how you practically delta hedge with real numbers, it could be useful for everyone here on ET.
Okay, but I want to emphasize that I'm not suggesting this play will work in 2008. The existence of the skew effectively eliminates it. I can show you how this play would work if all options traded at the same IV - how it worked in those golden days before the skew. If you understand how and why it would work if there was no skew, then you'll understand better the reason the skew exists. That was really my point. And I do think it's important for option traders to understand that if you're long options at one strike and short at another strike - as the underlying moves toward your long strike and away from your short strike, you will get long premium - long gammas and long vegas. As the underlying moves toward your short strike and away from your long strike, you will get short premium - short gammas and short vegas. I think that understanding how that works and why is an important step in developing conceptual fluency in options.