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Several factors should be considered when selecting the best fitting option strategy, but there is no factor more important than volatility. Volatility is crucial in the strategy selection process and every options strategist needs to be well versed on the types of trades that work best for particular volatility levels.

A successful options strategist is much like a golfer knowing which club to use or the fisherman when determining the best lure. An options trader should always know the strategy or types of strategies that are best for the current volatility environment. To that end there are two types of volatilities, those being statistical and implied.  Statistical volatility represents the standard deviation of a stock’s price changes from close to close of trading going back a specified number of days. Implied volatility is a measure of an underlying stock’s volatility as reflected in an option’s price. In other words, it is the volatility implied by the option’s current price.

Now the challenge for the options trader is to use this volatility information to select the best strategy. In general, the options strategist wants to sell high volatility in markets that are nonvolatile and buy low volatility in markets that are moving to garner a distinct trading edge.

To determine if a market is volatile or not the trader needs to compare current statistical volatility to past levels of statistical volatility. Volatile markets are ones that are showing current levels of statistical volatility greater than past levels and non-volatile markets typically are ones where current statistical volatility is less than past statistical volatility.

After the type of market has been defined, some further analysis needs to take place to determine if the options are currently undervalued or overvalued. To do this the options strategist has to take a look at implied volatility.  Options are considered cheap or undervalued when current implied volatility is less than past levels of implied volatility and also when current implied volatility is less than current statistical volatility. On the other hand, options are considered expensive or overvalued when current implied volatility is greater than past levels of implied volatility and also when current implied volatility is greater than current statistical volatility.

To illustrate some strategy selection decisions based on volatility consider entering long condors or even some of the higher risk strategies such as short straddles, short strangles or ratio spreads in non-volatile markets with expensive options. Keep in mind if you choose the higher risk strategies that you must execute adjustments in the direction the market moves to manage risk. For markets that are determined to be volatile and have cheap options, then the options trader should employ strategies like long strangles, long straddles, ratio backspreads; and if a definite directional bias is discerned, then selecting a straight call or put would be appropriate.

A volatility trader has to be flexible in their trade and strategy selection. They must be net buyers of premium when they expect implied volatility to increase and net sellers of premium when they feel volatility will decline. An options strategist ability to forecast whether volatility will rise or decline will largely determine how profitable they will be.

Predicting implied volatility is generally easier than forecasting market direction, since implied volatility tends to revert to its mean. In fact if the strategist chooses delta neutral type strategies like the long straddle or strangle then they do not need to forecast market direction, but you do need to react to market movement by adjusting.

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
jeff.neal@optionetics.com

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