The Mailbag is back! I have been saving up some interesting questions and am answering them in as detailed fashion as I can in two minutes or less (kidding it takes at least three as I type very slowly). If I didn’t answer a question that you have this time I am sure I will get to it. Keep them coming, either write them in the comments or email me Mark@option911.com
Eric's Question:
Hi Mark,
Could you give us some pointers in understanding volatility spreads across months and strikes to help us with techniques in order to better qualify changes in the marketplace? For instance, if the volatility spread changes between the front to back month, we can all infer what this means, but how does the experienced trader gauge the importance of this action? Take the S&P, as a trader do you know the historical average spread and then base decisions upon changes towards or away from this trend, or do you simply look backwards several days and interpolate a trade? What would a big move look like to you, and what methods to experienced traders use to qualify these spreads?
Mark Sebastian's Answer:
Wow Eric, that’s a mouthful of questions but I am happy to give it a shot. The first key to managing inter month spreads is to understand how they are moving. Are they widening or they tightening? The best way to do that is to actually keep track of spread. It is a pretty simple process, mark down the spread of the ATM options across several months. Next, keeping have an understanding of why that spread exists, how long it has been trading that way, and how long it may trade that way. The next step is to make sure the trader is keeping tabs on the week of the cycle as that can have a strong affect on the spread itself (read the weekend decay article again if you aren’t clear what I a mean). Monitoring how the spread has moved, why it has moved, and that it’s not just timing related will allow the trader to perceive edge. Finally, take action, if the trader understands when edge presents itself and has the confidence to take action he or she should be able to make money. Sometimes the trade will lose, however, over time if the trader capture ‘edge’ the trader will make money. I know it’s not exactly a how to book, but I hope that helps.
MKtMKR's Question:
Shouldn’t investing in bonds be superior to investing in equity? Debt earns interest, which are taxed under capital gains of around 15%, while equity earns corporate profits, which are taxed at 50% at the corporate level and 15% at the personal level. Certainly bonds return less, but if you levered up to the same volatility, say, using bull call spreads on AGG shouldn’t it perform better?
Mark Sebastian's Answer:
1st off lets clear up a few things, BOND INTEREST IS NOT CAPITAL GAINS! It is income. 
While certain bonds do have positive tax consequences, the tax consequences are usually priced into the interest the bond will receive. For instance, muni’s which are not taxed at the government level almost always have a lower interest rate. But the real answer lies in the limited upside of bonds. An investment grade coupon bond will typically only make whatever the trader pays under par plus the interests. Ownership, while certainly riskier can yield FAR greater return because there is no cap on the value of ownership. I think you are worrying too much about tax and not thinking about the vehicle itself. Although if you are interested in how bond OPTIONS trade my friend and co-worker Mark Fenton does an interesting bond blog
MKtMKR's Question:
I’m wondering how does the risk premium associated with leveraged buying of Eurodollar futures compare with selling options. One of things I am worried about as someone who trades SPX volatility is that I’m not diversified enough across asset classes. Are there similar premium earning strategies with other asset classes that could serve as diversification for the options seller?
Mark Sebastian's Answer:
WOW, TWO fun questions! There are certainly similar strategies in options in just about anything interest rate products, commodities, and stocks. The key is to understand how the underlying moves and works. Make sure you have a very strong understanding of any option product you trade.
Ron's Question:
It would be interesting and educational if you could briefly touch on what would you have done differently? Adjusting earlier maybe? Can adding an Iron Butter mitigate Vega Risk. Is this a proper way to reduce Vega on Cal? Thanks!
Mark Sebastian's Answer:
Going over my adjustment strategy and how I would have done things differently on my trades would be interesting and hopefully educational. It also would be a boat load of work. We here at option911 are currently evaluating doing something along this line though. As far the butterfly goes, the answer is yes and no. Yes it can mitigate vega risk, however, because of the intermonth spread and gamma risk it isn’t always the best choice. That said, there are certainly situations where it makes sense.
Nick's Question:
Good stuff! How can we monitor inter-month IV spreads to make sure we’re not setting ourselves up for a failed calendar?…Is it as simple as taking the IV of the 2 month’s strikes we’re considering and comparing them? What are guideline criteria we should use to keep ourselves out of a bad calendar? Thanks!
Mark Sebastian's Answer:
As stated above, take the time to write down the spread. Make sure to use the actually ATM strikes and not some blended VIX type equation (TOS and a few other trading platforms use those sometimes, they are horribly inaccurate).
Mark W's Statement:
Payment for order flow is gentleman’s terminology, from the day this practice began; I referred to it by its proper name: BRIBERY.
Mark Sebastian's Answer:
I am not saying I agree with you. I’m also not NOT saying I agree with you.
Anatole's Question:
I recently read the article How Market Makers buy UNITS to stay in business . I was curious. You talk about protecting yourself if you are very wrong. Do you ever consider ‘protecting’ yourself in the case you’re very right? In other words, what if ELAN had gone through the roof instead of taking a nose dive? Is that an outcome you consider spending some premium on? Do you consider buying some FOTM calls? I’m asking primarily from the point of view of selling puts or doing covered calls. One of the sort of lousy outcomes of either short puts or covered calls is that the stock shoots to the moon, and then there is the ‘regret’ which follows, since the stock gained say 50% and all you did was pocket the ‘lousy’ premium. I fully understand that the stock going up is actually the best possible outcome for the duration, but was wondering if you had thought about that scenario.
Thanks for any input,
Mark Sebastian's Answer:
Great questions! I think protecting yourself in case you are right is a great idea. However, I would never spend a large amount of money on upside protection. Here is an idea, instead of simply selling covered calls, sell credit spreads against your stock. Another idea, if you sell cash secured puts, take a small portion of your premium and buy a call somewhere, possibly in the back month. Thus if the stock does move up your position will produce more income. I would typically spend less 20% of my credit on either of these strategies.
There you have it, I hope you all enjoyed the mail this week!!
-Mark Sebastian
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