SPY Skew Trade
All examples are as of March 23, 2011.
This is the most complicated trade in the examples. It involves trading the difference in implied vols between different strikes. Lower strike options have higher implied vols than higher strike ones almost all the time. This is probably because stock market investors are more worried about a market decline than an move up, so they want to buy the lower strike puts. The difference between the implied vols of a low vs. a high strike is called the skew. Professional traders often take advantage of the skew in various ways. In this example, we will be shorting the skew; that is we will buy a high strike option and sell a low strike one. We will also be trading SPY shares in order to stay delta-neutral (to have a zero Delta for the whole position).
The trade is the following (all quantities in shares as always):
Long 1000 Apr 15, 2011 Calls with Strike = 134
Short 1000 Apr 15, 2011 Puts with Strike = 123
Short 340 Shares
This complicated trade gives us a Delta-neutral position (graph at right). The black line is about zero for the current price of about 129.66. If the market moves either way, our position will give us a positive Delta. As that happens, we may want to "Delta-Hedge" or re-zero our position by buying or selling shares. The pros do this a continual basis, so this strategy does involve staying in touch with the market. You can use OptionPosition+ to help you decide how to delta hedge.
The second graph is the gain/loss. As you would expect, if the market goes up and you do not Delta-hedge, you will make money as your calls become more valuable. Of course, you will lose on the downside. Note the red line: at most prices you will make money as time goes on. This is true even though you bought and sold the same number of options. The reason for this is the difference in implied vols; the put you sold were much more expensive than the calls you bought.