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As any good student of option trading knows, there are two steps to profiting in the options market:

1) Spot opportunity
2) Build a trade to take advantage of that opportunity

And this is exactly right. Still, there are lots of ways to spot opportunity and not everyone is looking for the same types of opportunities. And then, of course, within the realm of options trading there are numerous ways to take advantage of any particular opportunity. So for the sake of example, let’s look at some possibilities.

As anyone who learns about options knows, one key factor in selecting the strategy to use as well as the specific trade to take is implied volatility. Calculated by an option pricing model, the present level of implied volatility for the options on a given security tells you whether there is presently a lot of time premium built into the price of the options or not. In essence, it can tell you at a glance if the options on a given security are “cheap,” “expensive,” or somewhere in between.

At the moment, the level of implied volatility on average is somewhere beyond Mars on its way to Jupiter. A quick glance at Chart 1 provides a glimpse of the astronomically high level of option implied volatility that is presently the norm. In the chart you can see that over the past four years implied volatility on SPY options has typically fluctuated between 10% on the low side and 30% on the high side. At the far right-hand side of the chart you can see that the IV on short–term options recently spiked above 100%. This is likely an abnormal state that will not last forever (and it also reminds me of the old George Carlin weather forecast – “and winds will be light, 5 to 10 miles per hour, except gusting up to 90 in the hurricane”).

Chart 1 – SPY Implied Volatility spikes to abnormally high levels

Click here for larger view.

By making note of these unusually high levels of implied volatility we have in fact “spotted opportunity.”  For these high implied volatility levels tell us that there is an enormous amount of time premium built into option prices at the moment. This should not come as a surprise. The historic and relenteless declines in stock and commodity prices of late raised the fear level beyond what virtually all investors alive today have ever seen. In order to compensate themselves for assuming the risk of writing options in this environment, option writers are exacting steep, steep time premiums. This gets reflected in the high IV levels.

Given the exorbitant amount of time premium presently built into option prices, it makes a great deal of sense to consider strategies that allow you to sell premium.

What Might Happen From Here

More than anything else, the stock market hates uncertainty. At present there is possibily more uncertainty than at any time in our lifetimes. There is the credit crisis, the decline in home prices, recession fears, inflation fears, concerns over how much government can and should do and the fact that capitalism itself is presently being tarred as “past its prime.”  Needless to say, these are all good reasons for the financial markets to exhibit concern. Taken all together it has basically been a “perfect storm.”  And that uncertainty is likely to persist through the presidential election. Once the election is out of the way – and that uncertainty is lifted, one way or the other – a strong bounce in the market is quite possible. Regardless of when it comes, the fact is that once the market does rally – even if it is only a short-lived affair – implied volatility levels and, hence, time premium levels, will likely collapse in a hurry. So now would appear to be the time to consider the possibility of taking advantage of large time premiums.    

The first question you need to answer is whether you want to play a continuing decline in the market, a rebound in the market or take a neutral position. There are many possibilities. Let’s consider a few.

Riding the Bear?

If you expect the market (and most stocks) to continue to trend lower, and for IV levels to remain elevated, then consider a trade like the one depicted in Chart 2 and 3 using options on P&G. This strategy is referred to as an “OTM put butterfly."

Chart 2 – P&G 2-3-1 Put Butterfly
Click here for larger view. 

Chart 3 – P&G 2-3-1 Put Butterfly Risk Curves
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This trade only makes money if P&G breaks down through its recent low. If P&G were to break through, profits of 100% or more (of the $393 risk) are reached if P&G approaches or breaks down through $50 a share. This trade has about three months left until expiration (84 days) so there is plenty of time for the stock to make a meaningful price move. If P&G fails to break down, the maximum risk on the trade is $393. However, if P&G starts to rally a trader could presumaly exit the trade prior to expiration and avoid experiencing the maximum loss.

Looking for a Bounce?

Maybe you buy the “post election bounce” theory, accompanied by a sharp deline in volatility levels. Consider the bull put spread in Chart 4 and 5 using the options on the aforementioned SPY.

Chart 4 – SPY Bull Put Spread
Click here for larger view. 

Chart 5 – SPY Bull Put Spread Risk Curves
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Technically this trade has a profit potential of $115 and a maximum risk of $585. However, if you look at the risk curves in Chart 5 you see that a loss in excess of the maximum profit potential of $115 only occurs if SPY takes out its recent lows. So a trader could consider entering this trade and then plan to cut losses if the recent low is taken out and/or if a loss of $115 is incurred. With only 28 days left until expiration, any other scenario – particularly a post-election bounce accompanied by collapsing IV levels – will result in a possible 20% profit.  

Expecting a Wide Trading Range?

Figure the market will stay in a wide, volatile range for a while? No problem. Consider a trade like the butterfly spread on QQQQ options in Chart 6 and 7.

Chart 6 – QQQQ Call Butterfly
Click here for larger view. 

Chart 7 – QQQQ Call Butterfly Risk Curves
Click here for larger view.

This trade has some intriguing possibilities. If the market trends strongly in one direction this trade will ultimately lose money; however, the breakeven prices are about 20% away on both the upside and the downside. In addition, the dollar risk on this trade is exceedingly low to begin with ($104 for a single 1x2x1 spread). If the market were to whip back and forth through a large trading range, an early profit of 100% or more is possible. Also note that the vega on this trade is $-2.83. This means that if volatility falls, say, 20 points (quite possible if the market rallies) this trade can gain over $50 in profit solely from a decline in implied volatility.

Summary

As always I am compelled to emphasize that these are not “trading recommendations.”  In fact, given the way the markets are moving these days, by the time you view these trades, the opportunity depicted may be long gone. Still the real point here is that sometimes “spotting opportunity” may have little to do with market timing per se. In this case what really catches the eye is the astronomically high rate of implied volatility across virtually the entire option trading spectrum.

There is no guarantee that IV will fall signifcantly anytime soon; however, it is also unlikely that these levels can be sustained for very long. As a result, alert option traders should at least be looking for ways to use current option premium levels to their advantage. As you have seen in the examples above, regardless of your market outlook, there are ways to use options to generate profit opportunities.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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