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Jan 20, 2017

Analyzing Debit Spreads in Low Volatility Environments

By:Sage Anderson

If you took some time off for the winter holidays and are just returning to your trading desk, you certainly haven't missed much.

Just prior to Christmas, the SPY was trading around $226. Fast forward to mid-January and the SPY is only slightly higher at $227 and change.

Given those stats, it shouldn't come as much of a surprise that the VIX has also remained low through the most recent month of trading.

On December 21, 2016, the VIX closed about 11.25. As of January 13th, the VIX is almost exactly the same level - 11.23.

Because the low on the VIX from 2000 to present is just under 10, it's somewhat difficult to make the case that short volatility/premium trades are optimal with the VIX at 11 - especially those of extended duration.

It's important to be aware of broader market conditions when trading volatility, so the depressed levels in the VIX, combined with the fact that a new President is ascending to the White House, may represent a window of opportunity in your portfolio.

As highlighted in a recent blog post, extreme highs and lows in the VIX (and likewise in Implied Volatility Rank) can be a signal for volatility traders and assist them in strategy selection.

On that show, two trading structures were discussed that can leverage low volatility conditions:

  • Debit spreads

  • Calendar/Diagonal spreads

The reason these two strategies are suggested for low volatility conditions is that an expansion in volatility typically increases the value of such spreads.

A debit spread involves buying a closer to at-the-money (ATM) option, while simultaneously selling an out-of-the-money (OTM) option in the same underlying and expiration. A long calendar spread is executed by purchasing premium in a longer-dated expiration month against selling the same strike (calendar) or another strike (diagonal) in a nearer-term expiration month.

As opposed to taking an outright long volatility position, these spreads help reduce pure volatility risk through offsetting positions in another strike (debit spread) or another expiration cycle (calendar/diagonal). It's important to note that the offsetting risk also reduces the potential reward if volatility does explode.

If you are looking for more detailed information on debit spreads, a recent installment of Market Measures is a great place to start.

The episode, titled "Initiating and Managing Debit Spreads," walks viewers through the deployment of these positions and also examines some research conducted by tastytrade on the historical performance of debit spreads in SPY.

The analysis sought to evaluate whether debit spreads performed better when managing the positions at 50% of maximum profit (versus leaving on through expiration), as well as if the win rate improved when initiating such positions in lower volatility environments  (i.e. low IV Rank).

For the most comprehensive understanding of the material, we recommend you watch the entire episode of Market Measures focusing on debit spreads when your schedule allows.

In terms of high level results, the study showed that debit call spreads in SPY had outperformed put spreads over the course of the time period considered (2005 to present). Additionally, the data showed that managing these positions at 50% of maximum profit also increased the win rate of both debit call spreads and debit put spreads.

As you can see in the graphic below, the win rate and average P/L of both spreads also improved when deployed in lower IVR environments:

While strategy selection and timing will be largely dependant on your own unique approach and risk profile, the results of the study covered in this post may help you identify potential opportunities in the marketplace when volatility is depressed.

For those interested in learning more about strategies that may fit low volatility conditions, we also suggest viewing another episode from the Market Measures titled “Long Premium or Long VIX.”

If you have any questions about debit spreads or any other trading topic, we hope you’ll reach out at support@tastytrade.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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