It would seem to me managing ratio put spreads in a delta neutral strategy would be the smartest/easiest way to systematically "sell insurance" to the market, while taking advantage of the skew. For example, buy 1 $320 SPY put paired with selling 2 $310 SPY puts. Is this a popular trade? Second question... When dealers are selling puts and delta hedging, why wouldn't they pound the bid on the farther OTM options driving their vols down? If they are heding the delta along the way, why bother with selling anything near ATM, when you can get so much more vol farther out? I assume its related to risk/leverage. Thanks all!
This is called ratio spread and some people do trade them. Some blow up. Some people trade the opposite (back ratio spreads), meaning selling 1x $320P and buying 2x $310P or lower, whatever gives them credit (though also at debit). Some people use these back ratios as hedges. All this also depends on how far on the calendar you go. One guy described on ET in the past how he's made $50K+ (don't remember exact number) on his back ratios during a market pullback - that's again opposite to your trade, so you'd be giving him your money. Best thing to do is to open Think-or-Swim (demo if you don't have account with TDA) and look at historical option prices to check how much money you'd lose on Feb-5 2018, Feb-8 2018, and Dec-24 2018. I may not know the answer specifically but believe all options prices are in big part driven by demand. A dealer (which now may be anyone) may not have much to say with other dealers, hedge funds, and even retail traders arbitraging whatever is mispriced, or simply competing and taking over market-making business. If someone is selling something for too much then you compete by offering a better price. If something is too cheap then you buy as much as you can. In the end the prices have to meet in the middle where no one can take advantage of someone else.
Do you have a portfolio margin account? If not, then your front ratio credit's gonna be a teeny tiny return on margin. Do you have a trade in mind you'd care to share to exemplify your thinking?
It might sound odd, but you can think of volatility as a secondary consideration, nothing more than a variable. The essential component is its micro structure - the gamma/theta relationship and vol just ends up being where that fits, where risk/reward=1. If you 'pound' down vol you will be lowering theta and increasing gamma and moving that relationship away from where r/r=1. Not a good idea. You will be giving away money to someone that knows how to monetize it.
Thank you all. This might be true, but spreads don't use too much margin so its mainly the surplus naked puts at ~15% margin that would be the issue. An example as of today would be for Jan 17th expiry, buying 1 $323 put at 10% vol and selling 4 $305 puts at 17% vol. Delta is close to 0 and the spread costs is also close to $0. I am under the impression that since you are selling at such a higher IV, that if you did this trade a million times(assuming there is close to normal distribution of returns), its a near mathematical certainty you would make money. It seems like the IV would be representative of the other greeks, no? (and vice verse) Maybe said another way... If a stock has a realized vol of 10% and you are consistently selling with an IV of 15%, you make money in the long run, without considering any of the other greeks. And wouldn't gamma only rise on lower IV if you are ATM? OTM options should see there gamma decrease. Again, thanks for all the help.
Two ways of saying the same thing. I was expressing from the micro perspective exactly why you won't see HV of 10% trading IV of 15% for a longer term option. OMM ain't that dumb. Think relative to theta... those two always need to stay together.
Can you elaborate? My initial point was asking why market makers wouldn't sell vol far OTM to capture higher IV. If they are hedging delta I don't understand why you would want to sell at lower IVs(selling options ATM). Is flow entirely dictated by large buyers and not large sellers?
Oh. My apologies. It was early when I read that. I thought you meant long term. The reason is you are working off a faulty premise. ' take advantage of skew.' as though skew is some form of mistake. Skew is a modification of the BSM model because it is only capable of capturing price movement but doesn't accurately capture vol movement. So for many years it was easy to capture free gamma by buying wings and selling ATM. For many many years people argued incessantly that skew doesn't and shouldn't exist. Now it is accepted as fact but people still don't seem to understand why. Skew belongs there. This starts moving the convo into 2nd and 3rd derivative movements and beyond the scope of this website. But once again. Skew is not a mispricing. It is the correction to the BSM models limitations.
"Capture IV"?? MMs create IV, strike by strike, by virtue of their choice as to where they price their options.
Very interesting. I realize as prices fall vol will rise and the option sellers need to be compensated for this risk. Is this what you are saying? So if one were to systematically sell 50 delta puts and 10 delta puts, the 10 delta puts wouldn't be more profitable despite nearly always being sold at higher vols?