RDDT - Potential Money Printer? (Patreon)

I have an abusive relationship with single stock options.

After the original meme stonk fiasco, selling volatility on GME, AMC, BBBY, and a few other names printed money everyday for like 6 months. My PNL on that trade was a straight line up and to the right. It looked like Bernie Madoff's returns if Bernie was better at faking brokerage statements.

The first one's free.

Ever since then, every time I try to do it I just end up dying in a new and creative way each week.

This is a frustrating thing, because the volatility edge in these names is usually very obvious. You can see a massive historical spread between implied and forward realized volatility.

The problem is in the monetization of that spread.

Being that single stocks are both

• Not very liquid

• Trendy

There's a lot of stuff that goes into actually getting that edge, which means it's going to require some effort.

There are a few memey names right now where it's been working fairly well for me, so I wanted to make this post breaking down the trade.

This approach is based on a lot of ideas from other people that trade the single stonks, as well as some things I've observed that may or may not be real.

First, some background.

1. Single stock options are overpriced on average, but less so than index options

Most people wanna hedge their long stock portfolio with puts in the index, which means index options are the most overpriced.

However, single stock options are also overpriced.

Above is a chart from Positional Option Trading showing the average return of shorting a 1 month variance swap in different industries.

You can see basically all of them make money.

Unfortunately retail morons can't trade variance swaps or vol swaps, and instead have to trade options. This is the equivalent of using a chainsaw to try to carve a thanksgiving turkey, but it's the best we have.

The above chart is important because it shows there is generally an edge in being short volatility on single stocks.

Also while options suck to use, if there were a clean way to get volatility exposure in single names, the edge we're about to talk about probably wouldn't exist.

2. Stocks with steep skew tend to be overpriced

Skew is the tendency for out-of-the-money options (especially puts) to trade at a higher price than the at-the-money options.

                                                     SPY Implied Vol at different strikes

There are multiple reasons this is the case.

One is that more people want these options because they payout massively in the event of a crash.

Another is that the historical return distribution of the market has fat tails. Tail events happen more often than predicted by the normal distribution, and these options are priced higher to compensate for that.

Skew is also the market pricing in negative spot vol correlation. A fancy phrase that just means:

As a stonk go down, volatility go up.

This is the case in the index, because volatility increases as the market drops. That's why the OTM puts are priced higher than the calls as you can see in the plot of SPY skew above.

Memey names like RDDT have positive spot vol correlation. That means the market anticipates volatility to go up as RDDT stock goes up.

Below is the skew of RDDT. We can see it's upward sloping.

Spot vol correlation is important for volatility traders to understand, because it means making a bet on volatility is also implicitly making a bet on direction.

This is a pretty good guide on the intuition behind spot vol correlation if you're ever incredibly bored.

3. Single stocks trend

I've found trend is the single biggest problem when trying to extract the vol edge in single stocks.

The fact that single stocks trend means you need to do a lot of adjustments and hedges to keep your position from becoming a directional bet on the underlying.

Take the simplest form of shorting volatility: selling an at-the-money straddle.

If you sell the at-the-money straddle, as the underlying price moves away from your short strikes, your position loses gamma and gets delta, which means you no longer have exposure to the volatility you're trying to capture, you have a bet on the stock coming back towards those strikes, which is ultimately just a bet on direction.

The greeks make it sound complicated, but it's actually really simple.

Just imagine selling a deep in-the-money call. That position's PNL is entirely dependent on the stock going down. It's a directional bet.

When you open a short straddle and the stock moves way up (even if realized volatility remains very low on a close-close basis), you're now holding the bet above.

With single stocks, I've found the volatility prediction is the easy part.

The hard part is how you get a clean exposure to that volatility without paying away all of your profits in transaction costs as the stock trends in one direction.  

You're always on a continuum between costs and risk.

On one side of the spectrum

• The chad comes in, sells an at-the-money straddle on a memey name, and doesn't open his brokerage account for a week. His volatility forecast is right, but the stock blew out the straddle in a massive, but low-vol, trend. He would have made money if - as he saw he was accumulating deltas - he closed the straddle and opened a new one near ATM.

On the other side

• The virgin comes in restriking and adjusting his position every day. His volatility forecast is right, but he lost all his profits in the bid ask spread and transaction costs. If he wouldn't have been scared of accumulating a few deltas, he would have made a lot of money.

There's no real answer that works every time. I used to be the chad (as that's what worked with AMC and GME) but I'm now a lot closer to the virgin.

An edge in RDDT?

Shorting volatility has been a very good trade on RDDT over the past few weeks.

The implied volatility has come down substantially since I got into the trade, but still looks like a decent short imo.

Right now the May 3 call implied volatility is around 70%.

To put our annualized implied volatility figure into an implied daily move of the stonk, we can divide it by sqrt(252) or ~16.

So if we were to sell an IV of 70%, we're betting RDDT is going to move by less than 4.3%/day for the next 8 days.

 Looking at the May 10 expiration, we can see IV is around 100%. Almost 30% higher than the May 3 expiration.

This is because RDDT reports earnings on May 5th.

We can see this more obviously looking at the term structure.

                                                                     RDDT term structure 

That big kink at 15 days is the expiration with the most exposure to RDDT earnings. I'm definitely gonna be shorting RDDT through earnings.

Valuing RDDT Options

Below we can see the historical volatility of some comparable companies.

It's obviously not a perfect comparison, I was just trying to find some companies that might give us a decent prediction of RDDT's volatility going forward.

                                                         PINS non-event 20d and 90d volatility

                                                    SNAP non-event 20d and 90d volatility

~50% appears to be a decent estimate of volatility for the above names. I'm gonna take that as part of my forecast.

Measuring RDDT historical vol

Below is a 10d close to close measurement of RDDT's volatility.

Volatility has been declining since the IPO, and currently sits at around 65% based on a close to close estimation.

Being that today's volatility is the best estimation of tomorrow's volatility, it seems like we have around a 5% edge between the implied and historical.

Average this with our relative value forecast, and it seems like we have around a 10% vol edge in the trade.

To be clear, I think the edge here is that this is a risky meme name. It's less about the specific forecast number, and more about the situation. I just wanted a number I could put in my trade tracking sheet.

Measuring volatility a different way

Sometimes I don't like using the above realized vol measurement, because it can be deceptive.

Ultimately we're not measuring volatility for the sake of measuring it, we're doing so to try to make money.

That means we may want a measurement that's going to more closely approximate our results from selling volatility on the stock.

To the point from earlier, retail morons don't get to trade vol swaps, which means the path the stock takes (choppy or trendy) means a lot in how much we're gonna make.

The simplest way to think about a straddle is it's literally the amount a stock would need to move by expiration to breakeven. 

So if I sell a straddle with 10dte for $10 on a $100 stock, if the stock is at $109 at expiration, I'm gonna make money.

If the stock is $115 at expiration, I'm gonna lose money.

This is a good rule of thumb for retail degenerates to know, because often you just wanna bet that "the stock isn't gonna move x amount by expiration".

This is what the chad from the previous example does. He says "the straddle is $10, and we're not gonna move $10 up or down by expiration".

Right now the 8 day Reddit straddle can be sold immediately for $3.30.

RDDT is $41, which means the straddle (sold at bid) is a bet that the stock won't move more than ~8% in either direction in the next 8 days.

We'll likely get a better fill than the bid as well.

Below are the 8d returns of RDDT, so we can see how trendy/choppy it has been. It appears to be chopping around a bit more now since the big rally after the IPO.

When I trade single stocks i'm never purely the chad or virgin.

If my delta gets too big, I'll close my position, see if I still want to be in the trade, and restrike it at-the-money if I do.

Usually, when I feel the need to restrike the position, it means I was just wrong on my vol forecast, and I won't put it back on.

I find you can also tell when the stock is moving due to randomness, or moving due to some catalyst that might trigger more future volatility. Keeping close tabs on that is important I think.

RDDT doesn't look like amazing vol sell it was over the past month IMO, but I still think It's good enough for me to continue to gamble on.

Structuring the Trade

I usually do a half straddle/synthetic straddle in these trades because I think it's usually easier to get a good fill on a single option leg compared to multiple legs.

A half straddle is

• Short 1 call

• Long 50 shares of stock

or

• Short 1 put

• Short 50 shares of stock

This gives you the exact same payoff as a straddle, because the long/short shares flatten your delta on the option leg.

In Interactive Brokers, you can use 'ctrl D' in the strategy builder to attach a delta hedge to your option order.

I usually don't do this, and instead just work the option order until I get filled, then long/short shares after manually.

Some rules of thumb I've learned from a former option market maker: 

If your order doesn't get filled in under 10 minutes, you're not going to get filled at that price, so adjust your price if you still want the trade.

If you do happen to get filled after 10 minutes, the price moved against you and you got picked off.

Usually if my order doesn't fill in under 10 minutes, I'll just walk it penny by penny towards the bid.

Selling the very OTM calls in RDDT is very risky, but probably has the highest expected returns of any options.

Due to the positive spot vol correlation, these are going to explode in value if the market senses another meme rally. So much so that I'm too scared to sell them.

Right now I'm short the April 26 41.5 and 42.5 calls, and long 290 shares of stock.

I'll probably open another for the May 3rd expiration when it expires tomorrow.

GL everyone.

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