How To Use Volatility For Profits

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How To Trade Volatility – Chuck Norris Style!

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Volatility Trading Made Easy – Effective Strategies For Surviving Severe Market Swings

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Volatility Trading Made Easy – Effective Strategies For Surviving Severe Market Swings

** UPDATED FOR 2020 **

When trading options, one of the hardest concepts for beginner traders to learn is volatility, and specifically how to trade volatility. After receiving numerous emails from people regarding this topic, I wanted to take an in depth look at option volatility.

In this article you will learn:

This discussion will give you a detailed understanding of how you can use volatility in your trading. Let’s get stuck in!

Option Trading Volatility Explained

Option volatility is a key concept for option traders and even if you are a beginner, you should try to have at least a basic understanding. Option volatility is reflected by the Greek symbol Vega which is defined as the amount that the price of an option changes compared to a 1% change in volatility.

In other words, an options Vega is a measure of the impact of changes in the underlying volatility on the option price.

All else being equal (no movement in share price, interest rates and no passage of time), option prices will increase if there is an increase in volatility and decrease if there is a decrease in volatility.

Therefore, it stands to reason that buyers of options (those that are long either calls or puts), will benefit from increased volatility and sellers will benefit from decreased volatility.

The same can be said for spreads, debit spreads (trades where you pay to place the trade) will benefit from increased volatility while credit spreads (you receive money after placing the trade) will benefit from decreased volatility.

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Here is a theoretical example to demonstrate the idea. Let’s look at a stock priced at 50. Consider a 6-month call option with a strike price of 50:

If the implied volatility is 90, the option price is $12.50
If the implied volatility is 50, the option price is $7.25
If the implied volatility is 30, the option price is $4.50

This shows you that, the higher the implied volatility, the higher the option price. Below you can see three screen shots reflecting a simple at-the-money long call with 3 different levels of volatility.

The first picture shows the call as it is now, with no change in volatility. You can see that the current breakeven with 67 days to expiry is 117.74 (current SPY price) and if the stock rose today to 120, you would have $120.63 in profit.

The second picture shows the call same call but with a 50% increase in volatility (this is an extreme example to demonstrate my point). You can see that the current breakeven with 67 days to expiry is now 95.34 and if the stock rose today to 120, you would have $1,125.22 in profit.

The third picture shows the call same call but with a 20% decrease in volatility. You can see that the current breakeven with 67 days to expiry is now 123.86 and if the stock rose today to 120, you would have a loss of $279.99.

Why Is It Important?

One of the main reasons for needing to understand option volatility, is that it will allow you to evaluate whether options are cheap or expensive by comparing Implied Volatility (IV) to Historical Volatility (HV).

Below is an example of the historical volatility and implied volatility for AAPL. This data you can get for free very easily from www.ivolatility.com .

You can see that at the time, AAPL’s Historical Volatility was between 31-37% for the last 10-30 days and the current level of Implied Volatility is around 35%.

Notice that the current levels of IV, are much closer to the 52 week high than the 52 week low. This indicates that this was potentially a good time to look at short volatility strategies that benefit from a fall in IV.

Here we are looking at this same information shown graphically.

You can see there was a huge spike recently (Feb 2020) as the market was selling off on coronavirus fears.

This coincided with a 12.5% drop in AAPL stock price. Drops like this cause investors to become fearful and this heightened level of fear is a great chance for options traders to pick up extra premium via net selling strategies such as credit spreads or iron condors.

Also, if you were a holder of AAPL stock, you could use the volatility spike as a good time to sell some covered calls and pick up more income than you usually would for this strategy.

Generally when you see IV spikes like this, they are short lived, but be aware that things can and do get worse, such as in 2008, so don’t just assume that volatility will return to normal levels within a few days or weeks.

Every option strategy has an associated Greek value known as Vega, or position Vega. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Positive Vega strategies (like long puts and calls, backspreads and long strangles/straddles) do best when implied volatility levels rise.

Negative Vega strategies (like short puts and calls, ratio spreads and short strangles/ straddles) do best when implied volatility levels fall.

Clearly, knowing where implied volatility levels are and where they are likely to go after you’ve placed a trade can make all the difference in the outcome of strategy.

Historical Volatility and Implied Volatility

We know Historical Volatility is calculated by measuring the stocks past price movements. It is a known figure as it is based on past data. I want go into the details of how to calculate HV, as it is very easy to do in excel. The data is readily available for you in any case, so you generally will not need to calculate it yourself.

The main point you need to know here is that, in general stocks that have had large price swings in the past will have high levels of Historical Volatility. As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade.

Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it and this is where Implied Vol comes in.

– Implied Volatility is an estimate, made by professional traders and market makers of the future volatility of a stock. It is a key input in options pricing models.

The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs, of which Vega is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.

Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock. This could include and earnings announcement or the release of drug trial results for a pharmaceutical company.

The current state of the general market is also incorporated in Implied Vol. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised.

One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.

How To Trade Implied Volatility

The way I like to take advantage by trading implied volatility is through Iron Condors . With this trade you are selling an OTM Call and an OTM Put and buying a Call further out on the upside and buying a put further out on the downside. Let’s look at an example and assume we place the following trade today (Oct 14, 2020):

Sell 10 Nov 110 SPY Puts @ 1.16
Buy 10 Nov 105 SPY Puts @ 0.71
Sell 10 Nov 125 SPY Calls @ 2.13
Buy 10 Nov 130 SPY Calls @ 0.56

For this trade, we would receive a net credit of $2,020 and this would be the profit on the trade if SPY finishes between 110 and 125 at expiry. We would also profit from this trade if (all else being equal), implied volatility falls.

The first picture is the payoff diagram for the trade mentioned above straight after it was placed. Notice how we are short Vega of -80.53 . This means, the net position will benefit from a fall in Implied Vol.

The second picture shows what the payoff diagram would look like if there was a 50% drop in Implied vol. This is a fairly extreme example I know, but it demonstrates the point.

How To Trade Volatility Using the VIX

The CBOE Market Volatility Index or “The VIX” as it is more commonly referred is the best measure of general market volatility. It is sometimes also referred as the Fear Index as it is a proxy for the level of fear in the market.

When the VIX is high, there is a lot of fear in the market, when the VIX is low, it can indicate that market participants are complacent. As option traders, we can monitor the VIX and use it to help us in our trading decisions. Watch the video below to find out more.

There are a number of other strategies you can when trading implied volatility, but Iron condors are by far my favorite strategy to take advantage of high levels of implied vol. The following table shows some of the major options strategies and their Vega exposure.

I hope you found this information useful. Let me know in the comments below what you favorite strategy is for trading implied volatility.

Here’s to your success!

The following video explains some of the ideas discussed above in more detail.

Taking advantage of volatility with options

The long strangle is a strategy designed to profit when you expect a big move.

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If you expect a stock to become more volatile, the long strangle is an options strategy that aims to potentially profit off sharp up or down price moves.

What is a strangle?

The more volatile a stock (e.g., the larger the expected price swing), the greater the probability the stock may make a strong move in either direction. Like the similar straddle options strategy, a strangle can be used to exploit volatility in the market.

In a long strangle, you buy both a call and a put for the same underlying stock and expiration date, with different exercise prices for each option. The key difference between the strangle and the straddle is that, in the strangle, the exercise prices are different. In a straddle, the exercise prices are the same and normally established “at the money.”

One reason behind choosing different exercise prices for the strangle is that you may believe there is a greater chance of the stock moving in one particular direction, so you may not want to pay as much for the other side of the position. That is, you still believe the stock is going to move sharply, but think there is a slightly greater chance that it will move in one direction. As a result, you will typically pay a substantially lower net debit than you would by buying 2 at-the-money contracts for the straddle strategy.

For example, if you think the underlying stock has a greater chance of moving sharply higher, you might want to choose a less expensive put option with a lower exercise price than the call you want to purchase. The purchased put will still enable you to profit from a move to the downside, but it will have to move further in that direction.

A note about implied volatility

The downside to this is that with less risk on the table, the probability of success may be lower. You could need a much bigger move to exceed the break-evens with this strategy.

Here are a few key concepts to know about long strangles:

  • If the underlying stock goes up, then the value of the call option generally increases while the value of the put option decreases.
  • Conversely, if the underlying stock goes down, the put option generally increases and the call option decreases.
  • If the implied volatility (IV) of the option contracts increases, the values should also increase.
  • If the IV of the option contracts decreases, the values should decrease. This can make your trade less profitable, or potentially unprofitable, even if there is a big move in the underlying stock.
  • If the underlying stock remains unchanged, both options will most likely expire worthless, and the loss on the position will be the cost of purchasing the options.

Options agreement

Because you are the holder of both the call and the put, time decay hurts the value of your option contracts with each passing day. This is the rate of change in the value of an option as time to expiration decreases. You may need the stock to move quickly when utilizing this strategy. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from one of the options that increases in value so it covers the cost of buying both options and leaves you with a net gain.

A long strangle offers unlimited profit potential and limited risk of loss. Like the straddle, if the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range) or trades within the break-even range, you may lose all or part of your initial investment.

While higher volatility may increase the probability of a favorable move for a long strangle position, it may also increase the total cost of executing such a trade. If the options contracts are trading at high IV levels, then the premium will be adjusted higher to reflect the higher expected probability of a significant move in the underlying stock. Therefore, if the IV of the options you are considering has already spiked, it may be too late to establish the strategy without overpaying for the contracts.

In this situation, you may want to consider a short strangle which gives you the opportunity to effectively “sell the volatility” in the options and potentially profit on any inflated premiums.

Implied volatility rises and falls, impacting the value and price of options.

Short strangle

The short strangle is a strategy designed to profit when volatility is expected to decrease. It involves selling a call and put option with the same expiration date but different exercise prices.

The short strangle is also a non-directional strategy and would be used when you expect that the underlying stock will not move much at all, even though there are high expectations of volatility in the market. As a writer of these contracts, you are hoping that implied volatility will decrease, and you will be able to close the contracts at a lower price. With the short strangle, you are taking in up-front income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.

Long strangle example

Strangle versus straddle

In comparison, a straddle might be constructed by purchasing the October 40 call for $3.25 and buying the October 40 put for $2.50 at a total cost of $575. This is $150 more than the strangle cost in our example. Note that the stock would have to decline by a larger amount for the strangle position, compared with the straddle, resulting in a lower probability of a profitable trade.

This is the tradeoff for paying $150 less for the strangle, given the expectation that there is a greater likelihood for the stock to make a sharp move to the upside. Alternatively, the stock does not need to rise or fall as much, compared with the straddle, to breakeven.

Assume that in August, you forecast that XYZ Company—then trading at $40.75 a share—will move sharply after its earnings report the following month, and that you believe there is a slightly greater chance of a move to the upside. Due to this expectation, you believe that a strangle might be an ideal strategy to profit from the forecasted volatility.

To construct a strangle, you might buy an XYZ October 42 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 because each options contract typically controls 100 shares of the underlying stock. At the same time, you buy an XYZ October 38 put for $2.00, paying $200 ($2.00 x 100). Your total cost, or debit, for this trade is $425 ($225 + $200), plus commissions. 1

The maximum possible gain is theoretically unlimited because the call option has no ceiling: The underlying stock could continue to rise indefinitely. The maximum risk, or the most you could lose on the strangle, is the initial debit paid, which in our example is $425. This would occur if the underlying stock doesn’t move much during the life of the contracts.

The profit/loss options calculator can help you set up a strangle trade.

In this example, the cost of the strangle (in terms of the total price for each contract) is $4.25 ($2.25 + $2.00). Break-even in the event that the stock rises is $46.25 ($42.00 + $4.25), while break-even if the stock falls is $33.75 ($38.00 – $4.25). With this information, you know that XYZ must rise above $46.25 or fall below $33.75 before expiration to potentially be profitable.

How to manage a successful trade

Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $48.30 a share before the expiration date. Because XYZ rose above the $46.25 break-even price, our October 42 call option is profitable. Let’s assume it is worth $6.40. Conversely, our October put option has almost no value; let’s say it is worth $0.05.

Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for proceeds of $645 ([$6.40 + $0.05] x 100). Your total profit would be $220 (the gain of $645 less your initial investment of $425), minus any commission costs.

Another option you have before expiration is to close out the in-the-money call for $6.40, and leave the put open. Your proceeds will be $640 ($6.40 per share.) You lose out on $0.05 per share, or $5.00 (100 x $0.05) in sales proceeds, but you leave it open for the opportunity that the stock will go down before expiration and allow you to close it out at a higher premium.

Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $32 before expiration.

Because XYZ fell below the $33.75 break-even price, the October 38 put option might be worth $7.25. Conversely, the October 42 call option could be worth just $0.10. Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $10 ($0.10 x 100). The gain on the trade is $735 ($725 + $10), and the total profit is $310 (the $735 gain less the $425 cost to enter the trade), minus commissions.

Another option may be to sell the put and monitor the call for any profit opportunity in case the market rallies up until expiration.

How to manage a losing trade

The risk of the long strangle is that the underlying asset doesn’t move at all. Assume XYZ rises to $41 a few weeks before the expiration date. Although the underlying stock went up, it did not rise above the $46.25 break-even price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss to manage your risk, or you can wait longer and hope for a turnaround.

When considering whether to close out a losing position or leave it open, an important question to ask yourself is: “Would I open this trade today?” If the answer is no, you may want to close the trade and limit your losses.

Let’s assume that with just a week left until expiration, the XYZ October 42 call is worth $1.35, and the XYZ October 38 put is worth $0.10. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $145 ([$1.35 + $0.10] x 100). Your loss for this trade would be $280 (the $145 gain, minus the $425 cost of entering into the strangle), plus commissions. You might also consider selling the call that still has value, and monitor the put for appreciation in value in the event of a market decline.

The risk of waiting until expiration is the possibility of losing your entire initial $425 investment. You might also consider rolling the position out to a further month if you think there may still be an upcoming spike in volatility.

Other considerations

There are cases when it can be preferential to close a trade early. As mentioned, time decay and implied volatility are important factors in deciding when to close a trade. Time decay could lead traders to choose not to hold strangles to expiration, and they may also consider closing the trade if implied volatility has risen substantially and the option prices are higher than their purchase price. Instead, they might take their profits (or losses) in advance of expiration. Greeks can help you evaluate these types of factors. 2

The strangle can be a useful variation of the straddle strategy for those stocks you think will make a big move and you think there’s a greater chance of it moving in a certain direction.

Next steps to consider

Get new options ideas and up-to-the-minute data on options.

How To Profit From Volatility

How To Profit From Volatility

There is nothing certain in the stock market. The bulls and bears are in a constant battle for dominance and the winner can change in a heartbeat.

However, there are a few things that are very likely to happen in the not so distant future.

The first thing is that the Federal Reserve will start to increase interest rates. The central bank’s multi-year accommodative economic policy of quantitative easing and ultra low interest rates has worked its magic. The economy has been kick started back to growth.

History makes it clear that the stock market performs best during times of low interest rates.

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Secondly, the European Central Bank is ramping up its monetary easing programs in an effort to jump start the floundering euro zone economies. This means that European stocks will likely start to outperform which will divert U.S. investors away from the U.S. markets and into European stocks.

Chief Economic advisor for Allianz and noted financial leader, Mohamed El -Erian explained to CNBC,

“Investors should expect a lot more volatility and they should expect more of what they saw in the first quarter, which is the beta trade in U.S. equities not going to be as satisfying as it has been in the past.”

Thirdly, the spectre of higher interest rates will continue to strengthen the all ready soaring U.S. dollar. This means that multi- national corporations and other businesses that suffer when the greenback is strong will continue to face this headwind.

These items, when viewed together, create a very strong case that the stock market will start to move lower soon. Remember, individual stocks will continue to outperform regardless of what happens to the overall market. This is what El-Erian means when he says the beta trade will not be as satisfying as it has been in the past. The beta trade means a bet on the entire market by going long an index rather than picking individual stocks.

What Does All This Mean?

A dropping overall stock market means climbing volatility. In the stock market, volatility is measured by the VIX index. The VIX index will climb higher as the market drops lower.

The Volatility Index or VIX was first designed in 1993. Professor Robert Whaley is credited with creating the original idea.

Since options are priced based on the expected volatility or price changes over the next 30 days, the VIX reflects what option traders expect to happen in the next month. Think of options as insurance, the greater the fear of something bad happening, the higher the price of the insurance, therefore the higher the VIX index.

The above illustration from the Street.com clearly shows the negative fundamental event and what happened with the VIX reading during that time. The sharper the selling or expected selling in the stock market, the higher the VIX moves.

Breaking the VIX down to its formula, it is the square root of the par variance swap rate for the next 30 days.

There is no need for an investor to get bogged down in the actual math. The easiest way to think about the VIX is that it is the inverse of the S&P 500. In other words, the VIX moves opposite of the S&P 500.

The primary reason I like the VIX so much is that it is anticipatory. What this means is that the VIX often moves before the market does. This is because when professional traders strongly believe something negative is about to happen, they start buying options to insure against an adverse move. This means, that sometimes, but observing the action of the VIX , you can foresee what will likely happen in the stock market.

The VIX is resting near its 200 day simple moving average at 15. Provided the fundamental backdrop, it appears very likely that volatility will increase. In fact, it may increase dramatically over the next year.

Here Are 4 Ways To Profit From Volatility

  1. Trade the VIX

Since the VIX is an index, it cannot be traded directly. However, options and futures are available on the VIX index. One can sell VIX puts or buy VIX calls in anticipation of the VIX increasing. Just like with stocks, a variety of straddle and strangle option strategies can be employed to capture the volatility of the volatility index.

Looking at near the money October or November expirations is a suggested play on the VIX options.

  1. Own the Casino

Donald Trump is famous for saying the only people who make money gambling are the casino owners. While this is a little bit of a stretch for option traders since for every loser there is a winner on the other side of the trade, the wisdom can still be applied to the financial markets.

You can “own the casino” by purchasing shares in the Chicago Board of Options Exchange CBOE Holdings (NYSE:CBOE). Owning this stock is a great alternative for investors who don’t want to get involved with options. You see, as volatility increases, trading volumes in the options market increase, which in turn helps increase the profitability of the exchange. Spiking options volumes means more commissions and fees to the CBOE.

As you can see from the above chart of CBOE, price has fallen below the support level at the 200 day simple moving average. The suggested play here is to place your buy order just above the 200 day sma to catch the break out when volatility increases…

  1. Volatility ETN’s

As you know there is an ETF or ETN for almost any financial market you can imagine. One of the most popular VIX ETN’s is iPath S&P 500 VIX ST Futures (NYSE:VXX) This ETN allows the stock trader to benefit directly from the VIX futures without the need of a futures trading account.

As you can see from the chart, the VXX is trading near its recent lows.

Using orders to catch a break out of volatility would be my suggested play on the VXX. The reason being is that despite being convinced that volatility will increase soon, there’s no telling when exactly this will happen. Waiting for the upward price momentum to begin to buy is the wise move with this ETN.

  1. Look Outside The USA

The monetary easing in the euro zone should supercharge their stock market. Just like what happened in the United States when the easing programs started, European stocks should follow suit. Fortunately, you don’t have to open a special foreign trading account to access the European stock markets. Just like with the VIX, there are a wide variety of broad market European ETF’s that can be easily traded in your brokerage account.

My favorite euro zone ETF’s include SPDR STOXX Europe 50 ETF (NYSE:FEU) and Wisdom Tree Europe Dividend Growth Fund (NYSE:EUDG).

The Key Takeaways

The fundamental picture is pointing toward increasing volatility in the stock market. An index known as the VIX tracks the changes in volatility. Traders can take advantage of the likely volatility increase in many ways. Four of the most popular ways include trading options or futures directly on the VIX index, buying shares in the CBOE, using ETN’s and ETF’s to access the VIX with a stock trading account, and looking to the euro zone for investment opportunities.

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