A Scary Biotech Trade (Patreon)

One of the daily scans I like to do is high IV - RV spread. 

The idea is that when the spread between IV and RV becomes large, the market usually expects something big to happen. 

Generally, these are good places to sell options.

1. Find where the spread is large.

               Scan for high IV - RV spread for names with liquid options. I usually do
               this with some arbitrary threshold of option volume. Just enough to
               where I'll filter out any names whose transaction costs are going to
               completely erode the edge.

 2. Find out why the spread is large. 

Earnings, biotech press release, OPEC stuff (I don't understand oil),
elections, buyout rumors, CEOs thirsty Tinder DMs resurfaced, you get the idea. 

3. Recognize that options are usually overpriced in these situations because you've read Ben's Patreon and he said so.   

4. Find other historical examples, and try to conduct some kind of statistical analysis to determine whether options are, on average, overpriced

This statistical analysis doesn't need to be incredibly complicated. In the case of biotech, it could just be calculating the variance premium (lagging IV back 30 calendar days and then subtracting RV from IV) and then filtering out exclusively for these extreme events to see what the average is. This is of course the historical average (past performance... who gives a fuck), but if options have been overpriced in these situations historically, it's unlikely they'll stop being overpriced now. Not impossible, but unlikely.

In my scan, I came across $VERU -

$VERU's 7d options are very expensive right now. 

We can tell this isn't related to earnings, because earnings are on November 30th. 

There is definitely some Biotech fuckery going on here.  

We can see this reflected in the term structure. The market is anticipating something huge to happen in the next 10 days. 

I decided to sell some ATM straddles. This position means we're short volatility and neutral on direction. 

Because TD won't let me take undefined risk like the big boys, I also bought the deepest OTM wings I could. 

Stressing the Position

If we go into 'Risk Profile' in the Analyze tab, we can test to see how our pnl will look with different moves in the underlying.  

I analyzed a 10 lot short straddle position to see the damage from a 5 standard deviation move. 

Unfortunately, that 5σ isn't actually 5σ. 

Here, TOS is saying a 5σ move would be a 100% increase in VERU stock.   

A true 5σ event should happen roughly 1 in every 3,500,000 trading days. 

This differs from reality, where 100% upward moves in biotech happen weekly lol. 

All that to say, recognize that the reason the premium exists is because you're taking a risk other people don't want to take. These large moves happen more often than you'd expect, and they tend to be violent. 

That's why I like to size these positions really small and then diversify across a lot of sources of (hopefully uncorrelated - not really) edge.

You have to be a little bit cold-blooded to take these trades.  

I've eroded my emotional attachment to money so much at this point that I don't feel anything. 

The other day I had a $10,000 drawdown in my personal account - I was more upset when I drove home from Chic Fil A to find out they hadn't put sauce in the bag. Like honestly, THAT'S the fucking reason I go there! THE ENTIRE EXPERIENCE IS THE SAUCE. Now I'm just eating unhealthy chicken for NO REASON! 

Anyway.

When I saw this massive loss, It was like one of those scenes when the villain is watching an entire tribe on some planet get massacred; just nonchalantly eating an apple or something. Not giving a fuck. 

Short story long, I'd recommend sizing these positions smaller than you want to.  

I took this trade.