Beginning and intermediate traders have been asking me lately to describe the very basic and first-step decisions that take place when selecting from the variety of options strategies available. In attempt to do so, today’s Back to Basics will describe the fundamental steps that should go into determining which option strategy is best to apply.

The very first step in the decision tree is to evaluate the current implied volatility levels. Without going into an in-depth volatility discussion, implied volatility is the volatility implied by the options current price. This level can then be compared to the asset’s statistical or historical volatility, which measures the underlying’s price change in the past, to determine if implied volatility is high, low, or average.

Once the volatility level has been discerned then the options strategist must decide if they will be trading directionally with an upward or downward bias or will they be trading non-directionally or delta neutral where a definite market bias is not required.

Now that we have identified the decision points let us walk through the various choices the strategist is presented as they select the trade. First, assume a scenario where the option strategist has determined we have a high-implied volatility environment with a directional bias. Some of the strategies the trader could choose from are bull put spreads and bear call spreads. Why would these be two viable choices?  It’s because you are a seller of premium and take in a credit for the trade, which is exactly the type of strategy you want to apply in a high-implied volatility environment. The bull put spread would be used if you have a bullish bias and the bear call spread would be chosen for a bearish forecast.   

If in this same high implied volatility environment the trader wanted to take a more delta neutral or non-directional approach, then some of strategies to choose from would be time or calendar spreads, butterflies, or even condors. These strategies are appropriate since the goal for this level of volatility is to sell premium while at the same time not having a directional bias. As long as the market stays in a well-defined trading range these strategies can be quite effective.  

For a low implied volatility reading and the trader prefers a directional strategy they can select from some typical net premium buying strategies such as the purchasing of calls, puts, bull call spreads, and bear put spreads. If the strategist possesses a bullish directional bias then buying calls or putting on bull call spreads would be appropriate. However, if the options strategist possesses a bearish outlook then employing long puts and bear put spreads should be implemented at these low implied volatility levels.

If the trader wants to take on a non-directional approach at low implied volatility levels then straddles, strangles, put ratio backspreads and call ratio backspreads should be analyzed closely as a possible strategy. For these strategies in particular, an options analysis tool such as Optionetics.com’s Platinum is particularly helpful to differentiate which one of these delta neutral strategies would indeed be the best based on breakevens, risk/rewards etc.

I personally like volatility to be at extreme levels—high or low—before I select my strategy. However, if implied volatility is right at the middle of its historical range and you really want to trade that market, then I would suggest longer term wealth building directional strategies such as the bull call spread on LEAPS options. One could employ a bearish spread but more often than not you are better off in being long term bullish and if your technical indicators say so being a short-term bear.     

The bottom line is you need to match your volatility analysis with the best option strategy designed to take full advantage of that environment. There are many other advanced combination strategies that can be used for these environments, but remember this as you traverse through the basic option strategist decision flow chart: Be a buyer of option premium when implied volatility is low and be a net seller of option premium when implied volatility is at very high levels. Please make sure this trading maxim is clear as you continue to progress as an options trader.

Happy Trading.


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

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