Options volatility trading strategies

How To Trade Volatility – Chuck Norris Style!

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When trading options, one of the hardest concepts for beginner traders to learn is volatility, and specifically HOW TO TRADE VOLATILITY . After receiving numerous s from people regarding this topic, I wanted to take an in depth look at option volatility . I will explain what option volatility is and why it’s important. I’ll also discuss the difference between historical volatility and implied volatility and how you can use this in your trading, including examples. I’ll then look at some of the main options trading strategies and how rising and falling volatility will affect them. This discussion will give you a detailed understanding of how you can use volatility in your trading.

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.

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 ivolatility. You can see that at the time, AAPL’s Historical Volatility was between 25-30% for the last 10-30 days and the current level of Implied Volatility is around 35%. This shows you that traders were expecting big moves in AAPL going into August 2011. You can also see 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 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 in mid-October 2010. This coincided with a 6% 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, 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 TAKE ADVANTAGE BY TRADING 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 14,2011):

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.

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.

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38 Comments.

With volatility looking like it may be spiking back up again, now is a great time to review this article.

Thanks for the explaination, really clear and concise. This has helped me greatly with the iron condor strategy.

Glad to hear it Bruce. Let me know if there is anything else I can help you with.

haha thanks, I appreciate the feedback. Let me know if there’s is anything you think the site is missing.

Great Commentary and clear as a BELL!

Thanks! I appreciate the feedback.

I typically trade AAPL weekly options via verticals/iron condors. This wk with earnings on 10/25 the IV is extremely high and AApl like GOOG can have a huge move. Do you prefer the stangle/straddle strategies in a wk like this?

Typically I stay away from the weeklies to be honest, unless I am using them for a short-term hedge.

Clear n great illustration :). Need ur help on clarification. A long butterfly is a debit spread, why would it be suitable for decreased implied volatility compared to other debit spread? Thank you.

Is it due to the higher Vega on both the 2 ATM Call compared to both vegas of 1 ITM n 1 OTM? tq :).

This article was so good. It answered lot of questions that I had. Very clear and explained in simple English. Thanks for your help. I was looking to understand the effects of Vol and how to use it to my advantage. This really helped me. I do still would like to clarify one question. I see that Netflix Feb 2013 Put options have volatility at 72% or so while the Jan 75 Put option vol is around 56. I was thinking of doing a OTM Reverse Calendar spread ( I had read about it) However, my fear is that the Jan Option would expire on the 18th and the vol for Feb would still be the same or more. I can only trade spreads in my account (IRA). I can not leave that naked option till the vol drops after the earnings on 25th Jan. May be I will have to roll my long to March—but when the vol drops—-.

If I buy a 3month S&P ATM call option at the top of one of those vol spikes (I understand Vix is the implied vol on S&P), how do I know what takes precedence on my P/L : 1.) I will profit on my position from a rise in the underlying (S&P) or, 2.) I will lose on my position from a crash in volatility?

Hi Tonio, there are lots of variable at play, it depends on how far the stock moves and how far IV drops. As a general rule though, for an ATM long call, the rise in the underlying would have the biggest impact.

Remember: IV is the price of an option. You want to Buy puts and calls when IV is below normal, and Sell when IV goes up.

Buying an ATM call at the top of a volatility spike is like having waited for the Sale to end before you went shopping… In fact, you may even have paid HIGHER than “retail,” if the premium you paid was above the Black-Scholes “fair value.”

On the other hand, option pricing models are rules of thumb: stocks often go much higher or lower than what has happened in the past. But it’s a good place to start.

If you own a call — say AAPL C500 — and even though the stock price of is unchanged the market price for the option just went up from 20 bucks to 30 bucks, you just won on a pure IV play.

Good read. I appreciate the thoroughness.

I don’t understand how a change in volatility affects the profitability of a Condor after you’ve placed the trade.

In the example above, the $2,020 credit you earned to initiate the deal is the maximum amount you will ever see, and you can lose it all — and much more — if stock price goes above or below your shorts. In your example, because you own 10 contracts with a $5 range, you have $5,000 of exposure: 1,000 shares at 5 bucks each. Your max out-of-pocket loss would be $5,000 minus your opening credit of $2,020, or $2,980.

You will never, ever, EVER have a profit higher than the 2020 you opened with or a loss worse than the 2980, which is as bad as it can possibly get.

However, the actual stock movement is completely non-correlated with IV, which is merely the price traders are paying at that moment in time. If you got your $2,020 credit and the IV goes up by a factor of 5 million, there is zero affect on your cash position. It just means that traders are currently paying 5 million times as much for the same Condor.

And even at those lofty IV levels, the value of your open position will range between 2020 and 2980 — 100% driven by the movement of the underlying stock. Your options remember are contracts to buy and sell stock at certain prices, and this protects you (on a condor or other credit spread trade).

It helps to understand that Implied Volatility is not a number that Wall Streeters come up with on a conference call or a white board. The option pricing formulas like Black Scholes are built to tell you what the fair value of an option is in the future, based on stock price, time-to-expire, dividends, interest and Historic (that is, “what has actually happened over the past year”) volatility. It tells you that the expected fair price should be say $2.

But if people are actually paying $3 for that option, you solve the equation backwards with V as the unknown: “Hey! Historic volatility is 20, but these people are paying as if it was 30!” (hence “Implied” Volatility)

If IV drops while you are holding the $2,020 credit, it gives you an opportunity to close the position early and keep SOME of the credit, but it will always be less than the $2,020 you took in. That’s because closing Credit position will always require a Debit transaction. You can’t make money on both the in and the out.

With a Condor (or Iron Condor which writes both Put and Call spreads on the same stock) your best case is for the stock to go flatline the moment you write your deal, and you take your sweetie out for a $2,020 dinner.

My understanding is that if volatility decreases, then the value of the Iron Condor drops more quickly than it would otherwise, allowing you to buy it back and lock in your profit. Buying back at 50% max profit has been shown to dramatically improve your probability of success.

Yes, that’s exactly right. Apologies Jim Caron, I must have missed replying to your initial comment.

How would you replicate/replace an equity portfolio that is $50k long IWM and $50k short SPY with options? I tried buying ATM SPY puts where my notional was $50k and buying IWM calls where my notional was $50k, but I’ve found it essentially becomes a long straddle/volatility. please help.

You would be better off doing that with futures.

In order to replicate a long position in a stock using options, you would sell and ATM put and buy and ATM call.

A synthetic short position would be sell 1 ATM call, buy 1 ATM put.

Just found your site on facebook. Fantastic site, I love how you break down some difficult topic and communicate them in a very easy to understand fashion. Keep up the good work.

Thanks Ivan! You’re actually the second person to say that this week, so I must be doing something right. 🙂

Thanks for your comment.

Of course we know you put in a deliberate mistake too see if we are paying attention. There is no greek symbol called Vega. If we were using a Greek symbol it would be Kappa.

Great analysis. How do you play a possible expansion in VOL? a Ratio Backspread?

Hi John, I like double diagonals. See below:

There are some expert taught traders to ignore the greek of option such as IV and HV. Only one reason for this, all the pricing of option is purely based on the stock price movement or underlying security. If the option price is lousy or bad, we always can exercise our stock option and convert to stocks that we can owned or perhaps sell them off on the same day.

What is your comments or views on exercise your option by ignoring the option greek?

Only with exception for illiquid stock where traders may hard to find buyers to sell their stocks or options.

I also noted and observed that we are not necessary to check the VIX to trade option and furthermore some stocks have their own unique characters and each stock option having different option chain with different IV. As you know options trading have 7 or 8 exchanges in the US and they are different from the stock exchanges. They are many different market participants in the option and stock markets with different objectives and their strategies.

I prefer to check and like to trade on stocks/ option with high volume/ open interest plus option volume but the stock higher HV than option IV.

I also observed that a lot of blue chip, small cap, mid-cap stocks owned by big institutions can rotate their percentage holding and controlling the stock price movement.

If the institutions or Dark Pools (as they have alternative trading platform without going to the normal stocks exchanges) holds a stock ownership about 90% to 99.5% then the stock price does not move much such as MNST, TRIP, AES, THC, DNR, Z, VRTX, GM, ITC, COG, RESI, EXAS, MU, MON, BIIB, etc.

However, HFT activity also may cause the drastic price movement up or down if the HFT found out that the institutions quietly by or sell off their stocks especially the first hour of the trading.

Example: for credit spread we want low IV and HV and slow stock price movement. If we long option, we want low IV in hope of sell the option with high IV later on especially prior to earning announcement.

Or perhaps we use debit spread if we are long or short an option spread instead of directional trade in a volatile environment.

Therefore, it is very difficult to generalise things such as stock or option trading when come to trading option strategy or just trading stocks because some stocks have different beta values in their own reactions to the broader market indexes and responses to the news or any surprise events.

You state: “Example: for credit spread we want low IV and HV and slow stock price movement.”

I thought that, generally, one wants a higher IV environment when deploying credit spread trades…and the converse for debit spreads…

so ideally we want the volatility to contract / be ‘minimum’ when buying call debit spreads?

what about the case of market index etf’s like SPY, DIA or Qs? when we are in a debit call spread, bull call spread, and volatility expands / increases, the price of underlying will also drop, as volatility is contrarian, debit call spread’s value will decrease. but if volatility contracts or gets smaller, the price of underlying increases as does value of debit call spread. please explain.

Yes, you vol to be low when buying spreads, no matter if your trading a stock or an ETF. Remember volatility is only one piece of the puzzle. Yes if price drops, vol will rise, but you may be losing money on the spread as the price movement will likely outweigh the rise in vol. If price stays the same and vol rises, you make money.

If you buy a bear put debit spread, you make money from price and vol when the market drops.

Hi 2 questiions,

1. in the article tou mention Long vega benefits from high volatility is this because higher volatility im0lies higher prices in the underlying?

2. Also you mentioned in the volatility example , current levels of AAPL were 35% closer to the 52week high, hence indicating a fall in IV…could you explain this a little more, and would that mean if the IV level of 35% Was close to the 52week low, it would mean increase in IV ?

1. Yes. I you are long Vega and implied volatility rises, you will benefit from the higher option prices.

2. Typically you want to buy volatility when it is low and sell it when it’s high (just like a stock, buy low, sell high). So in this example, with volatility being close to a 52 week high, you would want to sell volatility, in the expectation that it will come down again. Volatility is different to stocks in that it is mean reverting, so if it’s high, it will generally come down and if it’s low, it will generally rise at some point.

Thank you for so many great articles on volatility. You explain things very well.

What P&L simulation tool are you using to price options and spreads above in this article? Is it available for free? It looks very nice and useful. Where can we download it? Keep up the great work on explaining how options volatility works.

This is from a broker called Options House.

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Strategies for Trading Volatility With Options (NFLX)

There are seven factors or variables that determine the price of an option:

Current price of the underlying Strike price Type of option (Call or Put) Time to expiration of the option Risk-free interest rate Dividends on the underlying Volatility.

Of these seven variables, six have known values, and there is no ambiguity about their input values into an option pricing model. But the seventh variable—volatility—is only an estimate, and for this reason, it is the most important factor in determining the price of an option.

Volatility can either be historical or implied; both are expressed on an annualized basis in percentage terms. Historical volatility is the actual volatility demonstrated by the underlying over a period of time, such as the past month or year. Implied volatility (IV) , on the other hand, is the level of volatility of the underlying that is implied by the current option price.

Implied volatility is far more relevant than historical volatility for options’ pricing because it looks forward. Think of implied volatility as peering through a somewhat murky windshield, while historical volatility is like looking into the rearview mirror. While the levels of historical and implied volatility for a specific stock or asset can be and often are very different, it makes intuitive sense that historical volatility can be an important determinant of implied volatility, just as the road traversed can give one an idea of what lies ahead.

All else being equal, an elevated level of implied volatility will result in a higher option price, while a depressed level of implied volatility will result in a lower option price. For example, volatility typically spikes around the time a company reports earnings. Thus, the implied volatility priced in by traders for this company’s options around “earnings season” will generally be significantly higher than volatility estimates during calmer times.

Volatility, Vega and More.

The “Option Greek” that measures an option’s price sensitivity to implied volatility is known as Vega. Vega expresses the price change of an option for every 1% change in volatility of the underlying.

Two points should be noted with regard to volatility:

Relative volatility is useful to avoid comparing apples to oranges in the options market. Relative volatility refers to the volatility of the stock at present compared to its volatility over a period of time. Suppose stock A’s at-the-money options expiring in one month have generally had an implied volatility of 10%, but are now showing an IV of 20%, while stock B’s one month at-the-money options have historically had an IV of 30%, which has now risen to 35%. On a relative basis, although stock B has the greater absolute volatility, it is apparent that A has had the bigger change in relative volatility. The overall level of volatility in the broad market is also an important consideration when evaluating an individual stock’s volatility. The best known measure of market volatility is the CBOEVolatility Index (VIX), which measures volatility of the S&P 500. Also known as the fear gauge , when the S&P 500 suffers a substantial decline, the VIX rises sharply; conversely, when the S&P 500 is ascending smoothly, the VIX will be becalmed.

The most fundamental principle of investing is buying low and selling high, and trading options is no different. So option traders will typically sell (or write) options when implied volatility is high, because this is akin to selling or “going short” on volatility. Likewise, when implied volatility is low, option traders will buy options or “go long” on volatility. (For more, see: Implied Volatility: Buy Low and Sell High . )

Based on this discussion, here are five option strategies used by traders to trade volatility, ranked in order of increasing complexity. To illustrate the concepts, we’ll use Netflix Inc (NFLX) options as examples.

Buy (or Go Long) Puts.

When volatility is high, both in terms of the broad market and in relative terms for a specific stock, traders who are bearish on the stock may buy puts on it based on the twin premises of “buy high, sell higher,” and “the trend is your friend.”

For example, Netflix closed at $91.15 on January 29, 2016, a 20% decline year-to-date, after more than doubling in 2015, when it was the best performing stock in the S&P 500. Traders who are bearish on the stock can buy a $90 put (i. e. strike price of $90) on the stock expiring in June 2016. The implied volatility of this put was 53% on January 29, 2016, and it was offered at $11.40. This means that Netflix would have to decline by $12.55 or 14% from current levels before the put position becomes profitable.

This strategy is a simple but expensive one, so traders who want to reduce the cost of their long put position can either buy a further out-of-the-money put, or can defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread. Continuing with the Netflix example, a trader could buy a June $80 put at $7.15, which is $4.25 or 37% cheaper than the $90 put. Or else the trader can construct a bear put spread by buying the $90 put at $11.40 and selling or writing the $80 put at $6.75 (note that the bid-ask for the June $80 put is $6.75 / $7.15), for a net cost of $4.65. (For related reading, see: Bear Put Spreads: A Roaring Alternative to Short Selling .)

Write (or Short) Calls.

A trader who is also bearish on the stock but thinks the level of IV for the June options could recede could consider writing naked calls on Netflix in order to pocket a premium of over $12. The June $90 calls were trading at $12.35/$12.80 on January 29, 2016, so writing these calls would result in the trader receiving premium of $12.35 (i. e. the bid price).

If the stock closes at or below $90 by the June 17 expiration of the calls, the trader would keep the full amount of the premium received. If the stock closes at $95 just before expiration, the $90 calls would be worth $5, so the trader’s net gain would still be $7.35 (i. e. $12.35 - $5).

The Vega on the June $90 calls was 0.2216, so if the IV of 54% drops sharply to 40% soon after the short call position was initiated, the option price would decline by about $3.10 (i. e. 14 x 0.2216).

Note that writing or shorting a naked call is a risky strategy, because of the theoretically unlimited risk if the underlying stock or asset surges in price. What if Netflix soars to $150 before the June expiration of the $90 naked call position? In that case, the $90 call would be worth at least $60, and the trader would be looking at a whopping 385% loss. In order to mitigate this risk, traders will often combine the short call position with a long call position at a higher price in a strategy known as a bear call spread.

Short Straddles or Strangles.

In a straddle , the trader writes or sells a call and put at the same strike price in order to receive the premiums on both the short call and short put positions. The rationale for this strategy is that the trader expects IV to abate significantly by option expiry, allowing most if not all of the premium received on the short put and short call positions to be retained. (For more, see: Straddle Strategy: A Simple Approach to Market Neutral . )

Again using the Netflix options as an example, writing the June $90 call and writing the June $90 put would result in the trader receiving an option premium of $12.35 + $11.10 = $23.45. The trader is banking on the stock staying close to the $90 strike price by the time of option expiration in June.

Writing a short put imparts on the trader the obligation to buy the underlying at the strike price even if it plunges to zero, while writing a short call has a theoretically unlimited risk as noted earlier. However, the trader has some margin of safety based on the level of premium received.

In this example, if the underlying stock Netflix closes above $66.55 (i. e. strike price of $90 - premium received of $23.45), or below $113.45 (i. e. $90 + $23.45) by option expiry in June, the strategy will be profitable. The exact level of profitability depends on where the stock price is by option expiry; profitability is maximum at a stock price by expiration of $90, and reduces as the stock gets further away from the $90 level. If the stock closes below $66.55 or above $113.45 by option expiry, the strategy would be unprofitable. Thus, $66.55 and $113.45 are the two break-even points for this short straddle strategy.

A short strangle is similar to a short straddle, the difference being that the strike price on the short put and short call positions are not the same. As a general rule, the call strike is above the put strike, and both are out-of-the-money and approximately equidistant from the current price of the underlying. Thus, with Netflix trading at $91.15, the trader could write a June $80 put at $6.75 and a June $100 call at $8.20, to receive net premium of $14.95 (i. e. $6.75 + $8.20). In return for receiving a lower level of premium, the risk of this strategy is mitigated to some extent. This is because the break-even points for the strategy are now $65.05 ($80 - $14.95) and $114.95 ($100 + $14.95) respectively.

Ratio Writing.

Ratio writing simply means writing more options than are purchased. The simplest strategy uses a 2:1 ratio, with two options sold or written for every option purchased. The rationale is to capitalize on a substantial fall in implied volatility before option expiration. (For more, see: Ratio Writing: A High-Volatility Options Strategy . )

A trader using this strategy would purchase a Netflix June $90 call at $12.80, and write (or short) two $100 calls at $8.20 each. The net premium received in this case is thus $3.60 (i. e. $8.20 x 2 - $12.80). This strategy can be considered to be the equivalent of a bull call spread (long June $90 call + short June $100 call), and a short call (June $100 call). The maximum gain from this strategy would accrue if the underlying stock closes exactly at $100 shortly before option expiration. In this case, the $90 long call would be worth $10 while the two $100 short calls would expire worthless. The maximum gain would therefore be $10 + premium received of $3.60 = $13.60.

The Profitability or Risk of Ratio Writing.

Let’s consider some scenarios to evaluate the profitability or risk of this strategy. What if the stock closes at $95 by option expiry? In this case, the $90 long call would be worth $5 and the two $100 short calls would expire worthless. The total gain would therefore be $8.60 ($5 + net premium received of $3.60). If the stock closes at $90 or below by option expiry, all three calls expire worthless and the only gain is the net premium received of $3.60.

What if the stock closes above $100 by option expiry? In this case, the gain on the $90 long call would be steadily eroded by the loss on the two short $100 calls. At a stock price of $105, for example, the overall P/L would be = $15 - (2 X $5) + $3.60 = $8.60.

Break-even for this strategy would thus be at a stock price of $113.60 by option expiry, at which point the P/L would be: (profit on long $90 call + $3.60 net premium received) - (loss on two short $100 calls) = ($23.60 + $3.60) - (2 X 13.60) = 0. Thus, t he strategy would be increasingly unprofitable as the stock rises above the break-even point of $113.60.

Iron Condors.

In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the same expiration, hoping to capitalize on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options.

The iron condor is constructed by selling an out-of-the-money (OTM) call and buying another call with a higher strike price, while selling an in-the-money (ITM) put and buying another put with a lower strike price. Generally, the difference between the strike prices of the calls and puts is the same, and they are equidistant from the underlying. Using Netflix June option prices, an iron condor would involve selling the $95 call and buying the $100 call for a net credit (or premium received) of $1.45 (i. e. $10.15 - $8.70), and simultaneously selling the $85 put and buying the $80 put for a net credit of $1.65 (i. e. $8.80 - $7.15). The total credit received would therefore be $3.10.

The maximum gain from this strategy is equal to the net premium received ($3.10), which would accrue if the stock closes between $85 and $95 by option expiry. The maximum loss would occur if the stock at expiration is trading above the $100 call strike or below the $80 put strike. In this case, the maximum loss would be equal to the difference in the strike prices of the calls or puts respectively, less the net premium received, or $1.90 (i. e. $5 - $3.10). The iron condor has a relatively low payoff, but the tradeoff is that the potential loss is also very limited. (For more, see: The Iron Condor . )

The Bottom Line.

These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility. Since most of these strategies involve potentially unlimited losses or are quite complicated (like the iron condor strategy), they should only be used by expert option traders who are well versed with the risks of option trading. Beginners should stick to buying plain-vanilla calls or puts.

Option Volatility: Strategies and Volatility.

The long call and the long put have positive Vega (are long volatility) and the short call and short put positions have a negative Vega (are short volatility). To understand why this is, recall that volatility is an input into the pricing model - the higher the volatility, the greater the price because the probability of the stock moving greater distances in the life of the option increases and with it the probability of success for the buyer. This results in option prices gaining in value to incorporate the new risk-reward. Think of the seller of the option - he or she would want to charge more if the seller's risk increased with the rise in volatility (likelihood of larger price moves in the future).

The easy answer is the size of the premium on the option: The higher the price, the larger the Vega. This means that as you go farther out in time (imagine LEAPS options), the Vega values can get very large and pose significant risk or reward should volatility make a change. For example, if you buy a LEAPS call option on a stock that was making a market bottom and the desired price rebound takes place, the volatility levels will typically decline sharply (see Figure 11 for this relationship on S&P 500 stock index, which reflects the same for many big cap stocks), and with it the option premium.

3 Option Strategies To Use During Low Volatility Markets.

February 7, 2014.

Low volatility trading is tough for option sellers like us.

When markets are calm premiums are small and narrow - meaning that we cannot sell options far from the current stock price.

So what's a trader to do!?

Staying active, and keeping position size small, is important but you don't want to force trades into the market that aren't right.

Here are three options strategies you can use during these low volatility times:

1) Put/Call Debit Spreads.

Make some directional bets on overbought or oversold stocks. Using debit spreads, you'll pay to enter the strategy and will look to pay about 50% of the width of the strikes.

This shouldn't be a big position (when should it ever) and you should try to have some plays on both sides.

The idea here is to keep active and close the trade out early when it shows a profit.

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2) Ratio Spreads.

If your directional assumption is extremely strong, you can use a ratio spread.

The spread P&L diagram below is for a call back spread where you sell 1 call and then buy 2 calls at a higher strike.

Since you are long 2x more options then you are short you'll be happy to see an increase in volatility. But remember that it's a big directional assumption (much more so than the debts spreads above).

3) Put/Call Calendars.

Calendars are great for low volatility markets! You have to be a little careful on your direction and I suggest using put calendars more than call calendars because volatility usually rises as markets fall.

Here you'll sell the front month option and buy the back month option taking advantage of the time decay and a possible rise in volatility.

Another tip is to make sure that the front month option has enough premium to make it worth the trade. Don't sell a front month option with .10 or .20 of value - it's just not work the investment.

About The Author.

Kirk Du Plessis.

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D. C., he’s a Full-time Options Trader and Real Estate Investor.

He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.

Enjoyed your article! Good tips for a low-volatility environment. I like using the debit spreads personally. Also, I believe you meant to say “worth”, not “work” in the last sentence on Put/Call Calendars.

Thanks Matthew! Yes I did mean to say that haha – typing way to fast.