Volatility is the heart and soul of option trading. With the proper understanding of volatility and how it affects your options you can profit in any market condition. The markets and individual stocks are always adjusting from periods of low volatility to high volatility, so we need to understand how to time our option strategies.
When we talk about volatility we are referring to implied volatility. Implied volatility is forward looking and shows the “implied” movement in a stock’s future volatility. Basically, it tells you how traders think the stock will move. Implied volatility is always expressed as a percentage, non-directional and on an annual basis.
The higher the implied volatility the more people think the stock’s price will move. Stocks listed on the Dow Jones are value-stocks so a lot of movement is not expected, thus, they have a lower implied volatility. Growth stocks or small caps found on the Russell 2000, conversely, are expected to move around a lot so they carry a higher implied volatility.
When trying to decide if we are in a high volatility or low volatility market we always look towards the S&P 500 implied volatility, also known as the VIX. The average price of the VIX is 20, so anything above that number we would register as high and anything below that number we register as low.
When the VIX is above 20 we shift our focus into short options becoming net sellers of options, and we like to use a lot of short straddles and strangles, iron condors, and naked calls and put. The trick with selling options in high volatility is that you want to wait for volatility to begin to drop before placing the trades. Don’t short options as volatility is climbing. If you can be patient and wait for volatility to come in these strategies will pay off.
Short Strangles And Straddles
Short strangles and straddles involve selling a call and a put on the same underlying and expiration. The nice part about these strategies is that they are delta neutral or non-directional, so you are banking on the underlying staying within a range.
If you are running a short strangle you are selling your call and put on different strikes, both out of the money. The strangle gives you a wider range of safety. This means your underlying can move around more while still delivering you the full profit. The downside is that your profit will be limited and lower compared to a straddle and your risk will be unlimited.
To gain a higher profit but smaller range of safety you want to trade a short straddle. In this strategy you will sell your call and put on the same strike, usually at-the-money. Here you are really counting on the underlying to pin or finish at a certain price.
In both of these strategies you don’t need to hold till expiration. Once you see volatility come in your position should be showing a profit so go ahead and close out and take your winnings.
If you like the idea of the short strangle but not the idea that it carries with it unlimited risk then an iron condor is your strategy. Iron condors are setup with two out of the money short vertical spreads, one on the call side and one on the put side. The iron condor will give you a wide range to profit in if the underlying remains within your strikes and it will cap your losses.
The iron condor is our go to strategy when we see high volatility start to come in. The value in the options will come out quickly and leave you with a sizable profit in a short period of time. If, however, your prediction was wrong your losses will be capped so you don’t have to worry about blowing out your portfolio.
Naked Puts And Calls
Naked puts and calls will be the easiest strategy to implement but the losses will be unlimited if you are wrong. This strategy should only be run by the more experienced option traders. If you are bullish on the underlying while volatility is high you need to sell an out-of-the-money put option. This is a neutral to bullish strategy and will profit if the underlying rises or stays the same.
If you are bearish you need to sell an out-of-the-money call option. This is a neutral to bearish strategy and will profit if the underlying falls or stays the same. Both of these strategies should use out-of-the-money options. The further you go out-of-the-money the higher the probability of success but the lower the return will be.
When you see volatility is high and starting to drop you need to switch your option strategy to selling options. The high volatility will keep your option price elevated and it will quickly drop as volatility begins to drop. Our favorite strategy is the iron condor followed by short strangles and straddles. Short calls and puts have their place and can be very effective but should only be run by more experienced option traders.
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