One. You are making a generalization about vol to price to options. With most commodity options the exact opposite will take place. Heck, for that matter if base vol is low in equities and the market starts taking off too fast vol can increase. Let me give you an exercise. Buy a 50 Delta option. Sell 10 Delta options until you are vol flat. Do this against a low volatility. Now start taking up vol. Keep taking up vol. See what is happening to your net Vega position as you do this. It is not going to be good. I NEVER EVER allowed myself to have this position on. When it goes wrong you will know what it feels like to get fucked from so many directions simultaneously and so fast that you will never want to hear the word options ever again in your life.
If I am understanding you, you are just saying there ends up being more potential convexity in your vega position as you go farther OTM, right? Which is why they are more richly priced. As with any other insurance selling, I would assume though that the sellers are being MORE than compensated for this risk over the long run. That is what I am getting at. And if that is true, then I would think selling a 10 delta put should be more profitable(delta hedged, vol adjusted etc) than a 50 delta put.
Let me just tell you that I have 800 of these ratio spreads on SPX right now. But at different strikes and expirations, carefully calculated and backtested over the years. I use them to do a bit of market making (buying and selling them at near $0), while having to hedge continuously and sometimes getting outside of my available margin, though I usually can get out of that with cheap hedges, I have a bit of an edge here and cannot provide details but I’m surprised you continue coming up with examples without actually looking at historical data. Not even one peek at option chain for Feb 5-8 2018? That’s when many accounts totally blew up doing exactly what you’re describing. Why is it easier for you to provide more examples and try to trade something on a guess vs actually taking a quick look at what would happen to you on a bad day?
I still don't get it. That trade is ~$100 debit, and the 3 naked puts require ~$14k reg-t margin, and it's delta neg, bearish. You'd have to go 1:6 ($0 cost) or 7 (nearest 0 delta, at small credit). But even at 1:4, you're gonna tie up $14k for how many days, to make how much? Have you backtested it? I don't see this ending well for SPY or any equity index or anything with likely positive drift; a pullback's gonna wipe your many tiny gains, and a correction will seriously hurt. As @guru said, at the very least this idea'd have to be tested back at least 2 yrs. My 2 cents.
Because I am looking at returns over the long term. I understand on any given day, month, year things could get really bad. This sort of a strategy would be a very small part of my account.
tbh I am going off academic work on the volatility risk premium, which is why I have not done any back testing. Any advice on the best way to back test ideas?
Dude. Dude. That's the subject of a gazillion threads, here and elsewhere. Manually test if you have TOS or some other broker or 3rd party software; or pay out the nose for backtesting sites with limited capability; or code your own. Good luck. :-/
As long as you don’t go outside your margin even at 20% drop over 2 weeks (December 2018 was almost there), and trading such short time frames (2 weeks in your example) and trying to get as wide width between the strikes as possible - then generally you can try doing this, just being aware of the risk. I’m only not sure whether it’s a good idea to do this systematically at low volatility without backtesting. It would work much better at higher vol, and although those opportunities don’t come often, just a few such trades at high vol might generate more profit than 10x more low vol trades with much higher risk. You could try doing this incrementally, but for me that’s similar to manual backtesting that I sometimes do with ToS. They have a feature to simulate manual buying and selling options on different days and observing your P&L. Btw, I’d do what you described, at a few positions, if I simply wanted to buy SPY at a lower price. But that’s similar to selling naked puts, so you may also want to compare whether your approach would’ve been better than simply selling naked puts. I generally like basic short-term ratio spreads on higher vol instruments like TSLA. That could be a good testing ground as well.
Lets look at the 323 -310 1x 4 spread.. breakeven on the downside is 310 - 13/4 Lets just say you break even at 307 (which is only 5% down),and then you are naked short 3 puts- whatever hedges you got off... the 310's have Vega of apx .17 at 15 vol..If you believe the market will trade at 10 vol,theoretically you should be able to capture 5 vol handles which would be 5 x .17=.85. Im rounding up the vol to 10% on the 323 strike Keep in mind you are selling gamma at very low levels and your total edge for each 1x4 spread is 0.85... With that said.if you look at the 1/8 323 -310 1x4,if the market is unchanged and you never had to hedge,the 1x4 widens out to apx 1 dollar... Is it safe to assume once you capture your initial theoretical edge,you would close the position,or would you keep on delta hedging as the 323's are trading at 8 vol and the 310's are trading at 15 vol?? The "edge' has actually gone up,with less time till expiration..hmmmmm,tasty Heres the bottom line and this is what I encountered when I was the head trader of equity derivatives at a major investment bank.Its a question of when and not if before you encounter a large down gap down in the market.You wont get your hedges off and vol will explode in your face..You will give up most of your year in one to two days,you wont double down while you should and the pain will be brutal...keep in mind,its only a 4% gap down to get you to your max gamma.. I am a really fast defensive trader,and I got whacked on more than one occasion.It will happen to you... Either you trade small enough where you dont give a shit if you "own" the short puts,or trade big and buy some cheap wings,even though you give up edge... Sooner or later,selling 96% spot wings at 15 vol will get you.. Go big,and you are going home..