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As usual.. Cathie Wood is giving us some good option selling opportunities lol
To start, here's how I found this trade opportunity:
Ran an expensive options scan. Looked for
- Price above 15
- Avg option volume above 3000 daily contracts
- Implied vs realized 30 day vol ratio greater than 1.1
- No earnings event coming up in next 30 days
What is ARKG?
Another one of the darling children of Cathy Wood , this ETF is focused on companies that are expected to benefit from technological and medical improvements in the quality of human and length of human life.
Here are some of itās top holdings
This is how itās been moving recently:
It's been trading sideways for the most part, especially relative to what the market has been implying over the last 30 days.
The options market is basically implying that ARKG will move 2.8% per day over the next 30 days.
It has realized about 1.7% daily moves over the last 30 days and has been range bound, so the total move was just 4.57% to the downside.
Something I noticed is that ARKG got smoked back in the start of the year, which obviously causes implied volatility to increase as we look forward (especially if it is not volatility driven by a singular event).
But over the last few months, things have traded sideways for ARKG. For this reason, there has been a pretty good opportunity to sell options here over the last couple of months. Over time, we have seen the implied volatility level coming down, reflecting that things are calmer now for the holdings within ARKG.
We can actually see that across all expirations, implied volatility has come down by about 10 points.
Over this time period, we have seen a consistent risk premium.
This is the IV/RV ratio for ARKG. Times, where it is greater than 1.0, indicate a risk premium that was/is available. You can see that the risk premium has been pretty consistent since March.
The variance premium is also loosely autocorrelated - a fancy way of saying 'if this spread was big last month, it's more likely to be big this month'. Visualizing the size of the spread in historically is another thing that helps us make money. Cool.
So right off the bat, Iām almost thinking that this is a pretty good opportunity for me to come in and sell some volatility.
One concern I do have, though is that there isnāt very much liquidity. So getting a lot of size on this trade will be difficult. But looking at the spreads right off the bat, should be possible to get some lots on.
Checkpoint 1 summary:
- ARKG shows up in my scan for having expensive vols
- Consistent risk premium last couple of months
- Large vol increase in the past, slowly seeing implied volatility come down from the highs.
Before putting this trade on, let's go deeper into our analysisā¦
We have already compared ARKGās current option data against the past for it. But this doesnāt give us the full picture. We can also compare ARKG against correlated companies to see if there is any break in correlations that can indicate to us further that this is a good trade to take.
The first thing to do is actually find correlated companies for our comparison. Hereās the list I generated.
The reason that I want to find correlated companies is that if the price action for the stocks is similar, then the implied/realized vol ratios should be similar.
What we can do now is compare the IV/RV ratios for the correlated stocks, and if we see a break in their pattern, it can help us benchmark the āfair valueā of volatility for the ticker we are analyzing.
For this analysis, I chose to use ARKF as the comparison.
The first spread is the ratio for ARKG, the second spread is the ratio for ARKF.
We can see that in the last couple of weeks, the spread has significantly increased for ARKF compared to ARKG.
Being able to plot these spreads is absolutely critical in volatility trading. It clearly shows us that there has been some change recently. Since the companies are so highly correlated, it indicates that there could be a trade here.
The one thing we need to clarify first is: Does thing change arise because of an increase in IV for ARKF or because of a decrease in RV?
To answer this question, I plotted the IVs and RVs for both companies on the same graph. You can clearly see that what is driving the change in ratio is a decrease in RV for ARKF.
So hereās what we can conclude:
Since the companies are so highly correlated, we should see the IV/RV ratios for them move similarly. A spread has opened up that we can potentially trade, and the reason for this is the drop in RV for ARKF.
Since we are already evaluating ARKG from the perspective that options are expensive, this indicates that we should either see a drop in realized volatility for ARKG or an increase in realized volatility for ARKF.
Checkpoint 2 summary:
- ARKG is highly correlated with ARKF
- ARKG and ARKF have a similar IV/RV ratio historically
- The recent break in this trend is due to a drop in RV on ARKF
- For this spread to close, either RV drops on ARKG or rises on ARKF.
- IV dropping on ARKF could also cause this spread to close*
Overall, we can see that looking at the past (absolute valuation), ARKG options appear to be expensive. And when compared to ARKF, it also appears to be expensive.
All of this indicates that there is a trading opportunity to sell options on ARKG, and there is the potential to hedge this position by buying options on ARKF.
Depending on your margin availability, we could be outright selling options or including the hedge.
For now, I will be looking at just selling the ARKG volatility, or the āalpha legā of this trade, because, well, Iām a bit of a degen.
Now we know that options are expensive here, but as super duper smart traders, we want to be clear on how expensive these options are.
To do this, I will need to create my own forecast of what volatility should be.
I will do this by taking a blend of 3 things
- The PA forecast of volatility
- The historical average implied volatility for ARKG
- The RV that the ARKG options should be at to bring it back in line with ARKF
PA Forecast: 36%
Historical IV Average: 45% (IV has just been trending down over time)
IV/RV ratio adjustment: 29%
Now let's take an average of these: 36.6%
Given this forecast of volatility, here is the current price of the at the money straddle and the āfair valueā given our forecast of volatility.
Current market price for $28 straddle: $3.33
Our estimated fair value: $2.90
Premium based on our analysis: 14.8%
This seems good for something we can include in our option selling portfolio, so the next step is to actually structure the trade.
Here is the trade we could look to be putting on
I chose to do a June 16 expiry $28 straddle on ARKG. The image above shows you the payoff graph for this trade.
Position Sizing and Management.
For a trade like this, I am not looking to load the boat on it. This is just another part of a short volatility book, but with some good research to back it ( when you build a book of trades like this, you do pretty well). So I would be sizing this relatively small and stressing this position to a 1.5x straddle price move. I would use that as my max loss scenario where I would certainly be looking to cut the trade.
I am comfortable using this because ARKG is an ETF, so we donāt carry the same āblow-up riskā as single-name trades.
As for position management, I would continue to hold this trade if ARKG trends sideways and realizes less volatility than implied. If we start to see multiple days in a row of outsized moves or if the trend becomes too strong in one direction, I would look to exit early for a loss. If we see a drastic drop in implied volatility, that would also lead to an exit, but with this trade, I believe we will see RV underperform IV and a slight drop in IV (assuming we are correct).
Conclusion
I want to reiterate that liquidity is low on this ticker, so you probably wonāt be getting too much size on here, and for the lots that you can get on, you need to be very reserved with your fills. If you are too aggressive, you will give up too much edge, which can turn our EV bet into a -EV one.
Beyond that, I want to clarify that this is just one of many trades that should be a part of a short vol book. The research is solid, but the edge that it gives us is not enough for āLetās yolo our life savingsā.
So trade it small, find many trades of this nature, spread your risk, and reap those sweet sweet premiums.
Help me see what I am missing so I get wrecked.
As mentioned at the start of the post, I'd love to hear your thoughts on this trade. Is there any news or analysis that we should be considering here? What other implications should be included in our analysis?
if I hear nothing I will assume that I should yolo it all (lol).
If the community likes this content and idea I'll be happy to keep it going!
Happy trading,
~ AG
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