OUTSIDE THE BOX: Letting Volatility Drive Options Positions
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August 1, 2007
When selecting the best option strategy, many successful traders believe that there is no factor more important than volatility. Every options trader needs to be well versed on the variety of strategies that are the best fit for particular volatility levels.
There are two types of volatilities: 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.
It is important for the options strategist to use this volatility information to select the best strategy. Typically, the options trader 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.
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.
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. Conversely 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 a long condor 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 that if you choose the higher risk strategies, 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 a straight call or put would be appropriate.
A volatility trader has to be flexible in their trade and strategy selection. He or she must be net buyers of premium when implied volatility is expected to increase, and net sellers of premium when it’s felt that volatility will decline. An options strategist’s ability to forecast whether volatility will rise or decline largely determines how profitable the trade will be.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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Listen to Jeff at www.ProfitStrategiesRadio.com
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