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Vol for One, One for Vol: Trading Volatility with Options Spreads

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October 1, 2012
trade volatility options spreads
Fredrik Broden

The one constant in the world of options is that nothing's constant. And so goes volatility. But volatility, unlike a stock, doesn't typically move up without looking back. That's because it's “mean reverting,” which in geek-speak means it tends to rise and fall around an average level. Trying to figure out why a stock's implied volatility is high or low, won't do you as much good as simply determining the optimal strategy to take advantage of the volatility hand you're dealt— particularly on high-priced stocks.

Generally speaking, there are three volatility environments you'll need to consider: low, mixed, and high. Here's a few trend-trade strategies designed to meet each of these.

1—Low Vol—Backspreads

Is the stock you're looking at $20 or $200? If the latter, then a simple long-option strategy may be too pricey, despite low implied volatility. An at-the-money option on the $20 stock might be $2, but on a $200 stock, it could be $20. So what if you think the stock is poised for a nice drop in price, and you want to trade that downside? Perhaps a put backspread might come in handy.

A backspread is comprised of at least one near-money, or out-of-the-money (OTM) options series, and a greater quantity of long position, in a further OTM option series of the same class and expiration cycle. You want to try to put them on for a small credit.

What's the attraction? In addition to likely being less capital-intensive than their long-option counterparts, backspreads give you a two-pronged bet. They generally let you establish a credit in your favor, while getting you poised to take advantage of a rise in volatility. Putting them on for a credit may just provide you with a small profit, if the entire trade expires worthless. Second, you also have more long puts than short on a put backspread, and more long calls than short on a call backspread, so you could profit if the underlying moves sharply beyond your strike prices.

What's the downside? You lose in general if the underlying stock hovers near the long strike, and you lose big if you do nothing, and the stock closes right at your long strike.

Suppose stock XYZ is trading at $225. XYZ has rallied considerably over the past six months. You suspect the uptrend is tired, and the stock may drift over the course of the next two months, or possibly even crash hard. To put on a bearish put backspread, you'd sell, say, two August 220 puts in XYZ, for $11.50 (for a total credit of $2,300). Against that, you could theoretically buy four August $200 puts, for $5.00 each (for a total debit of $2,000). The margin you would need to put up is the difference between the short and long strikes (in this case, net-net, you take in a credit of $300.

An upward move in the stock is pretty straightforward. Your profit maxes out at the $300 you took in as a credit (less commissions and fees).

A downward move in the stock is trickier. If XYZ crashes, you could potentially cash in—again, thanks to owning the extra put. The lower it goes, the better.

Looking at a profit curve of the backspread in Figure 1, notice the change in the difference between the date of entry (red dash line), and trade expiration. As time passes, the potential loss increases, as time decay sets in the long options, with the greatest loss at the long-put strike.

Backspread

FIGURE 1: THE BACKSPREAD.

In low-vol environments, particularly on high-priced stocks, the backspread offers an alternative to expensive calls and puts. For illustrative purposes only.

However, the backspread's best performance comes if XYZ collapses immediately. That's because of the two additional long puts, which should benefit if XYZ declines—even if XYZ declines towards our long strike of $200.

If XYZ doesn't move quickly enough, however, you may not be so lucky. Though you typically don't want to hold a backspread until expiration, your worst-case scenario occurs if XYZ closes exactly at $200 on August expiration. The $220 puts you sold at $11.50 each expire at $20, which produces a loss of $1,750. What's more, the 200-strike puts you bought $5 each go worthless. That's another $2,000 down the drain. Since you took in a $300 credit at the onset of the trade, your total loss would be $3,450 (plus commissions and fees) in this scenario ($300 - $1,750 - $2,000). Ouch.

2—Mixed Vol—Long Vertical

When volatility is at heightened levels, but not too extreme, a long vertical spread is a defined-risk strategy designed to profit from a directional move, while also hedging volatility. It typically requires only a small investment—you simply need to cover the debit you incur.

With a long-call vertical, you're making a bullish bet by purchasing a call, and selling a higher-strike call of the same class and expiration, in equal amounts. (See Figure 2) With a long-put vertical, you're making a bearish bet by purchasing a put and selling a lower-strike put of the same class and expiration, in equal amounts as well.

Long call vertical

FIGURE 2: LONG CALL VERTICAL.

One benefit to a long vertical spread is you're buying and selling volatility, which essentially negates it. For illustrative purposes only.

Vega—the rate at which an option changes when volatility changes—is the culprit for taking money away from you, when volatility collapses in a long position. However, in a long vertical, the reason your negative vega is hedged somewhat, is because the volatility you sell in the short option, negates some of the volatility you're buying in the long option. It doesn't hedge all of it, but it helps. And you could still potentially benefit from a rise in volatility. More importantly, the long-vertical could position you to profit from the underlying stock move.

Suppose you're mildly bullish on hypothetical stock FAHN, but not interested in a big bet on option volatility. You could theoretically buy a call-vertical spread by purchasing 2 FAHN August 230 calls for, say, $9.00 ( = $1,800), and selling 2 FAHN August 240 calls for $6.00 (= $1,200), for a total outlay of $300 (plus commissions and fees). This is also your max risk. And your max reward is $7.00 per spread (less commissions and fees).

What's next? If you do nothing, and FAHN settles anywhere below $230, the spread goes out worthless, and you lose the entire $300. However, on the upside, if FAHN expires above $240, the spread is worth $10 ($240-$230). Since you paid $3.00 for it, you make the difference of $7.00 x 2, or $1400. Yay.

If FAHN closes anywhere in the middle of the strikes, you win or lose the difference between the intrinsic value of the spread, and the $3.00 debit you paid. So you break even at $233, and max out on profit potential at $240.

3—High Vol—Short Vertical

Suppose you're still bullish, or mildly bullish, on FAHN, but volatility is too high to purchase a long vertical spread. The risk/reward just isn't there. Instead of buying a call vertical, you sell an out-of-the-money put vertical spread. (Figure 3) Painting broad strokes, a stock can go up, down, or stay put. With stock, or long calls, or long vertical spreads, you lose in two of those three scenarios. But a short out-of-the-money put vertical can make money if the market goes up, stays the same, or even drops a bit—just as long as the stock is above the short strike at expiration.

Short out-of-the-money put vertical

FIGURE 3: SHORT OUT-OF-THE-MONEY PUT VERTICAL.

High volatility is a killer of long option strategies. That's why short verticals are designed to profit from a drop in volatility. For illustrative purposes only.

What does it look like? Using our FAHN example, suppose you short the August 220 puts at $11.50, and purchase the Aug. 210 puts at $9.50, for a credit of $2.00 each, or $200 per spread (less commissions and fees).

If FAHN expires anywhere above $220, you keep the $200 (less commissions and fees). If it closes below $210, your maximum loss is the difference between the strikes, less the $2.00, for a net loss of $8.00 per spread, or $800. If it closes in between, you lose intrinsic value, less the $2.00. For example, if FAHN finishes at 215, you lose $5.00 per spread, less the $2.00 your received, for a total of $3.00 per spread, or $300.

In the case of a short vertical, you're counting on volatility collapsing, which helps your trade. The sooner the volatility premium is pulled out of the options, the sooner you profit. On the other hand, should volatility increase, this would hurt your trade. You only profit if you can buy the spread back cheaper than you sold it for, or it expires worthless.

Obviously, short verticals are similar to long verticals. However, they're a modest bet against volatility. It's a great alternative to its unhedged cousin, the short-naked put. But with a short vertical, you have a built-in stop at your long strike, should the stock go awry.

High-priced stocks don't have to be intimidating, and neither does their volatility. These are just three of the many option spreads designed to mitigate your volatility risk and attempt to capitalize on the prevailing trend—without breaking the bank.