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This New Tool Will Tell You Whether Or Not An Options Spread Is A Good Deal

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One of the challenges of trading options is the lack of a comparison tool. Unlike stocks, options don’t have an index to compare them to. 

Sure, you can compare an option’s implied volatility against its historical volatility,
but that doesn’t tell you whether an option spread (strategy of buying and selling different options contracts simultaneously) is undervalued or overvalued based on past performance.

For example, let’s say you’re looking at a stock that costs $100 per share, and you want to put on a risk reversal strategy that’s 5% away from that price. So you end up:

  • Buying the 105 Call, with an IV of 45 and price of $3; and
  • Selling the 95 Put, with an IV of 55 and price of $4

We can see from this example that the put option is a little more richly priced compared to the call options because of the higher IV. But overall, is this trade a good deal or a bad deal? It’s impossible to say. 

“We have a lack of benchmarks in general in the options industry,” said Dmitry Parganamik, co-founder of options research platform MarketChameleon. “We have the VIX, but the VIX is not going to help you if you’re trying to do a credit put spread in IBM (NYSE: IBM). We don’t have these benchmarks, and they’re very important because it helps you make a quicker comparison.”

To solve that, Parganamik helped create a tool that does exactly that—compares the price of options to historical pricing. This is particularly useful, he said, when using options spreads, because of the variability of the different options legs. 

“Options are priced by implied volatility, and we have different implied volatilities depending on the option contract. So we have different implied volatilities on different expirations, we have different implied volatilities on different strikes. We call that skew. But how do we know if today’s skew is good or bad?”

A Practical Example

Let’s use a risk reversal trade in Apple Inc (NASDAQ: AAPL) as an example. According to MarketChameleon, a risk reversal trade that involves buying a call and selling a put +/- 5% from the current price of the stock and expires in 30 days will pay more than the 52-week average. 

screen_shot_2020-05-25_at_4.26.36_pm.png
Source: Marketchameleon

In short, this trade is a good deal compared to historical averages. To see how this trade could play out, a corresponding call and put that fit those parameters would result in the following:

screen_shot_2020-05-25_at_3.58.41_pm.png
Source: Marketchameleon

This trade, it should be noted, would most likely result in a profitable trade. The following chart shows a payout diagram at expiration for this strategy.

unnamed_1_1.png
Source: Marketchameleon

However, the real question here is about how the pricing and payout of this trade compares to historical patterns. We already know that this trade is a good deal compared to the 52-week average of calls and puts in Apple, but how much of a good deal is it?

unnamed_2_1.png
Source: Marketchameleon

On average, this trade would have resulted in you receiving a $0.50 credit for putting on this trade. But for making this trade right now, you’re receiving a $1.35 credit. 

In short, a risk reversal trade in Apple with a call that’s +5% from the current price and a put that’s -5% from the current price, where both expire in 30 days, will pay you more than twice as much as the historical average. 

Watch the full interview with Dmitry Parganamik on PreMarket Prep below.

 

Related Articles (AAPL + IBM)

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