When is a Spread Cheap or Expensive?

Discussion in 'Options' started by rrisch, Jul 2, 2006.

  1. rrisch


    You can always compare the IV of two options, on the same underlying, in order to have a good idea of their relative price and try to cook up a reasonable spread where the option(s) you sell has a higher IV than the one(s) you buy. However, AFAIK, you can't compute the IV of different spreads (more than 1 leg) and enter (buy) the one with the lowest IV. If I am mistaken about that, I would like a reference.

    So are there any recognized methods of ranking spreads from cheap to expensive? TIA.
  2. atozcom


    Depending if you are the seller or buyer of the spread, there really would be no such a thing as cheap or expensive, just good or bad price for the trade.

    I believe the cost of a spread at any moment would depend on the implied volatility of each component option which changes as price of the underlying going up and down at that moment.

    I have been watching the SPX August 2006 iron condor, one deviation OTM, 5 point width, with SPX at whatever price at the moment, for at least 3 weeks using the Thinkorswim platform. I have seen the same iron condor can be as low as $0.55 and as high as $1.77 and changes all day long.
  3. rosy


    you can look at the relative pricing.

    ATM calendar spreads should be more expensive than OTM/ITM cal spreads.

    a 10/15 call spread with the underlying at 12.5 should be around 2.5
  4. rrisch


    So as I thought, there is no single variable with which you reliably compare two spreads.

    I have noticed a website where they claim to have a novel approach to finding good entrances and exits to a fixed spread. It is called chartbender.com and this is what I can gather from the BS (not Black-Scholes) on the site. They use something they call "Daily P/L from Implied Volatility". They never tell you exactly what it is, but my guess is that it means:

    Today's Market Price of Spread - Theoretical Price of Spread using yesterday's IVs, of the individual legs, to compute today's theoretical price of the legs.

    They keep a running sum of these daily P/L from IV, starting from some point in the past. Sometimes they start from the first date you could actually put the spread on. They use technical analysis of the chart of this daily sum to decide on entry and exit points. For example an historically low value would be a good entry and historically high value a good exit. I doubt that there is much theory behind it and have no idea whether it works better than any other method. Comments?
  5. MTE


    I've never used Chartbender, but I did have a look at it and the way I see it is that their software tells you how much changes in volatility, time to expiry and price of underlying have individually contributed to your total p/l.

    So it may tell you, for example, that your total p/l is $500, out of which $300 was attributed to the change in the price of underlying, $400 due to the change in volatility and -$200 due to time decay.
  6. rrisch


    MTE, it isn't all that clear what analytical tools Chartbender gives you and how useful they are. But since they have a free trial, maybe we should find out.

    I should correct what I said above. I think that change in P/L due to IV means that you are fixing the time, underlying price and risk-free rate inputs to the pricing formula. Thus I should have said:

    Daily Change in Spread Price Due to Change in IV(s) = Current Spread Price - Yesterday's Theoretical Value computed with today's IV(s).

    The other P/L changes can be computed the same way. However, as anyone who has taken multi-variable calculus remembers, adding up these changes won't precisely equal the actual change in P/L. This is because the option price is not a linear function of the inputs to the pricing formula. A nice feature of the Chartbender approach is that it is not necessary to use a single value for the IV of spread. You can work with the IVs of the individual legs. Whether they acually do that, is unknown to me.
  7. You can do all of that with TOS analysis page. You can also hold any variable constant while you change the others. In my experience, the forecasted prices of the spread have been quite accurate regardless of which variable was changed.
  8. rrisch


    It just occurs to me that maybe there is a way to compare spreads on the same underlying, providing they match in both the number of short and the number of long options. I hope the readers of this thread will take the challenge of tearing down ths idea.

    You can compute the IV of any set of options on the same underlying providing they are all long or short. Repetitions are allowed. This follows from the fact that the sum of monotone increasing functions is again a monotone increasing function and thus has a unique monotone increasing inverse. In this case, the sum is, of course, that of the Black-Scholes options prices of the options in that set, expressed as a function of volatility, other variables held fixed.

    So the proposed measure to compare different spreads is the difference:

    IV of Short Options in the Spread - IV of Long Options in the Spread.

    I would think that the highest values of this difference, in the class of proposed spreads, should be prime candidates. Does anybody know if any of the many websites, that recommend options spreads use this criterion? I assume it would be easy to write Excel macros to compute it.
  9. Not sure if this is of any use in this discussion, which seems to have become rather convoluted.
    But if I'm looking to buy, for example, a vertical and I want to know which is the best vertical for a given expiration then I just look for the spread that doubles the fastest in value over that time frame. Once I find that, then that's the "cheapest" in my opinion.

    rrisch wrote: "So the proposed measure to compare different spreads is the difference:

    IV of Short Options in the Spread - IV of Long Options in the Spread"

    I don't think that is of much use in selecting your spread. For example, the iv gets pretty much neutralised in your "vanilla" verticals and thus isn't really an issue. In long calendars, however, you'd want iv to be low both front and back months. In long flys, you want high iv overall and hoping for a return to the mean shortly after opening the fly ....
    daddy's boy