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Embrace the Quiet: Consider Low-Volatility Option Trades

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June 18, 2015
Quiet volatility may hold option opportunities

Sometimes the road less traveled offers the best footing. The same might be said for the thinly trod, quiet opportunities that may be lurking in low-volatility option contracts.

Many option traders consider short-term premium collection strategies, otherwise known as “selling” strategies, as their bread-and-butter trades. But there are low-volatility “buying” strategies that may offer limited risk of loss if the trade doesn’t work out, and the possibility of a nice payoff if it does. It all starts with understanding what low volatility really means.

Back to Basics

Implied volatility just might be one of the most, if not the most, misunderstood part of option trading. Truly getting a handle on what implied volatility represents, and how to put that information to work, can be crucial for the option trader.

So before getting into “buying” strategies, here’s a quick primer. Implied volatility is the option market’s best guess for how much the underlying stock’s price may move in the future. It’s expressed as a percentage. So a 0.35 move is 35%, or “35 vol” in trader language. Typically, there’s a baseline, or a low point, that volatility reaches. When the volatility starts to move above this baseline, the stock is expected to have a bigger range going forward, and option prices, taking this into account, are considered more likely to get expensive.

Measured Calculation

Let’s chart this concept. In figure 1, which shows two years of data, the volatility for a sample stock tends to bottom out in the low 30s. Over the past couple of years, volatility had gotten as high as the mid-80s. So what’s the benefit of knowing this? It’s key to understanding whether you’re setting yourself up for a bad trade right from the get-go.

Relative low volatility

FIGURE 1: IT’S ALL RELATIVE. Implied volatility charts like this one (lower view) can help you decide if volatility is relatively high or relatively low at present compared to its range and how that knowledge could fit within a option strategy. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

The actual percentage itself isn’t typically what you’re interested in. What piques your interest might be relative value.

Relatively speaking, is this volatility high or low compared to its range? Is it high or low compared to where it could go? Looking at figure 1 again, many traders likely don’t want to buy options at point A, considering that volatility drops to point B within just a few days or weeks. That’s roughly akin to buying speculative property just before a housing bubble bursts. As volatility plunges, so does the value of options. And that’s not where long options traders want to be.

How’s Your Timing?

But as is seen in this example, with volatility just about as low as some traders say it normally goes, this is where a “buying” strategy, like a long straddle or strangle, can set you up to potentially collect profit, assuming the volatility stays within its range. Keep in mind that going long without other hedging risks 100% loss. Of course, it’s always possible that volatility could move to even lower lows, in which case option prices would continue to decline. But it’s also certainly much better than jumping in front of the train and buying options when volatility is near its high.

So looking at a trade from this angle, when you buy a strangle (for instance), you’re setting yourself up for the chance of potential profit if the stock moves in either direction—or if the volatility spikes higher.

You'll also need to consider time decay and decide how long you’re willing to stay in the trade. For example, you might look for these trade setup possibilities in earnings aftermath (implied volatility often spikes too much pre-earnings to make this trade effective). But stay disciplined! Many traders will avoid anything where the volatility has already moved substantially off the low. This road may be less traveled, but with volatility charts, at least you have a road map.

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