With more retail traders than ever, it was only a matter of time before the strategies deployed became faster, more sophisticated, and of course, more profitable.
Similar to the last strategy posted, in order to execute this strategy all you need is a laptop, and an internet connection.
The tech stack remains the same, as we will be using OpenBB’s research platform for data/analysis:
and the Options-Quant platform for pricing and execution:
This is a strategy that is based on math, but you do not need to know the granular details to make this strategy work.
The Black-Scholes formula is the most common method of pricing options. However, it is mainly useful for pricing European options. European options differ from American options in a few ways, but the most significant difference is that European options can only be exercised at expiration. American options, on the other hand, can be exercised at any time.
This means that American options usually carry a premium (added-on cost) that tries to account for the risk of the option being exercised early. This premium is not accounted for in the Black-Scholes model, so it is not a valid model for pricing real, tradable American options.
In comes the Barone-Adesi and Whaley (called BAW from hereon) model. The BAW model is a slight tweak to the Black-Scholes model. It accounts not only for the premium of exercise risk, but it also factors in dividends of the underlying stock. It does this by calculating the value of the option if it were to be exercised early, and adds it to the Black-Scholes calculated value.
More on this model can be found below, but again, it is not necessary for the trader to know the formulaic derivations:
This strategy will revolve around targeting implied volatility. We will first find liquid options that expire in less than 30 days and have an implied volatility that is near a short-term historical low.
Once we select the option that fits the criteria, we then price the option to get the BAW implied volatility (remember, we use BAW since it is a more accurate model of Black-Scholes. If this calculated implied volatility is higher than the one quoted by the market, we will try to capture that spread.
(Calculated IV — Market IV) = (Profit)
There are only a handful of ways to target implied volatility only, some expensive, some not accessible to retail. The absolute best, and most cost-efficient option will be to buy the straddle of that option and delta hedge it. This may sound scary and expensive, but as demonstrated below, it is a lot less expensive and difficult to implement than you may think.
First, we want to find our ideal option, so we use OpenBB terminal to screen for options that:
- Have an IV at least 5% lower than the 20-day historical IV
- Are no more than 5% out-of-the-money
- Expire in less than 30 days
We enter the following query:
stocks/options/screen/set low_IV/scr --export Output.csv
This uses the screener function to screen for options that match the above criteria, which we set in the low_IV preset (more can be found on custom presets here), finally it saves the matching results to a csv(Excel) file for neat viewing and further analysis.
Side note: It is optimal to stick to very-liquid names like SPY, AAPL, and QQQ, as getting out of the position is just as important as getting into it. However, this potentially limits total profits as the more illiquid, smaller names have much more pronounced inefficiencies.
We then calculate IV by plugging those values to the BAWbisection model (the bisection is a method of calculating IV, more can be found here.) First, we price the IV of the call.
We see that according to the BAW model, implied volatility at this level should really be priced at 26.90%, an almost 5% difference! When re-pricing IV for the put, the value given is 24.34%, about 3% higher.
So now, the trade is clear. We must buy the straddle (long the call and long the put) with the assumption that the calculated implied vol is a more appropriate and efficient value than the one quoted by the market. We only want to bet on the increase in volatility, we do not want the risks that come from price movements of the underlying, so we must delta hedge.
The Fun Starts
We buy the call and the put for a grand total of $7.65 (x100 multiplier). The position initially has a delta of 2. This means that for each dollar the price of the stock moves up or down, the value of our position will move by $2.
Since we do not want that exposure to price, we want our delta to be 0. Having a delta of 0 means that the value of our position will not move from the change in the underlying’s price. Being delta hedged allows us to profit/lose from the change in vega, or implied volatility. To get to delta-neutral, all we have to do is short 2 shares.
That’s right, that’s all delta hedging is. The cost of becoming delta-neutral can be found by taking (share price * shares traded), so in this case, (165.35 * 2) $330.7. You may have noticed that delta is not truly 0.00, this is normal as being delta-hedged refers to being as close to 0 as possible, since it is extraordinarily rare to have the deltas align at 0.00.
Now we are exposed mainly to changes in Vega (Gamma too, but since we’re dynamically hedging, it isn’t a significant risk.), or in other words, changes to implied volatility. Going back to the original example, we wanted to bet that the IV of the position would increase by at least 2%, so we will just keep this position delta-hedged and watch as IV moves.
Over the life/day of an option, the delta will move continuously, because the underlying moves continuously. For a stock like AAPL, the range is usually quite small, only requiring the trader to be short/long 5 shares at most. You can get used to delta-hedging by practicing in a paper trading environment. Deltas move quickly, so being quick on your feet will be a huge plus in this strategy.
As expected, the implied volatility of the position increased rather significantly. By 10 minutes before market close, the implied vol of the call increased from 21% to 27%, and the implied vol of the put increased from 21% to 24%. This allowed us to sell the call for $4.95, and the put for $4.35, for a total of $ 9.3 (x100 multiplier), making a profit of $165.
Don’t just take my word for it, you can pull the historical data and see exactly how this trade played out! Pictured below is the final options chain for August 5th, 2022 (the day of the position) — take note of the implied volatility and the prices.
If you’ve made it this far, congratulations, that was a doozie. To recap, we first isolated tickers susceptible to an increase in implied volatility by screening our low_IV preset on OpenBB. We then double-checked whether the IV was right by plugging the price into the BAW model with Options-Quant. When we found that the volatility levels were off, we went long volatility by buying the straddle and delta-hedging it. Finally, the implied volatility worked itself back to a reasonable level, and we were able to capture a profit from that spread.
The retail trading space is very quickly catching up to that of institutions. Years ago, commissions and fees would eat this strategy alive, but now, the total cost in fees and commissions equate to less than $5. It is fascinating to watch the natural evolution of strategies from momentum, to technical analysis, and now, to full-fledged quantitative strategies.
Disclaimer: I am not professionally affiliated with these platforms, I gain no financial benefit or incentive from this article.
Let me know how your adventure goes and how I might have helped, I love hearing the success stories emailed to me.