Saturday, June 7, 2014

Which index option provides better premium return per volatility?

Major indices have their own volatilities over the last 5 years as shown in the chart below. The volatility $RVX of RUT is consistently higher than those ($VXN and $VIX) of NDX and SPX. For example, RUT had a 59% higher volatility than SPX on June 6 of 2014. This difference was on the high side. On March 1 of 2010, RUT volatility was 17% ((20.43-17.42)/17.42) higher than that of SPX which was a normal difference. The volatility of NDX is only slightly higher than that of the SPX most of times.

Karen stated she prefer to trade SPX over NDX and RUT. She had a good year (probably 2009) trading RUT with relatively higher return. But she likes the lower risks trading SPX. She does not want to trade NDX which has higher risk with similar return rate.
How do we know we are getting a good return for the risk of a trade using each vehicle of different volatility? I made a simple attempt to investigate the covered return per implied volatility of each trade and showed the results in the top right corner of the above chart. Basically, the covered return for each call and put option on 6-7-2014 were obtained from the TOS analyzer. The options had 41 days to their July expiration date. The calls had around 10% ITM probability and the puts had around 5% ITM probability. The implied volatility of each individual option was obtained from the TOS analyzer as well. I assume the ratio of covered return over IV would give us a fair measurement of return for the IV of each trade.

As can be seen in the table embedded in the above chart, selling puts of SPY, IWM, and QQQ would have similar returns (about 6%) on this date. Given SPY is less volatile, SPY put would be a good choice. For the short calls with 41 DTE, SPY does have lower returns (12.8%) than IWM (14.5%) and QQQ (14.6%). Please be advised that this study includes one set of data from one day only. It may not be generalized for other days. Further study is required to understand it more deeply.

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