The recent rise in volatility means it could be time to talk about strategies designed to capitalize on elevated volatility levels.
Trading options is more than just being bullish or bearish or market neutral. There’s volatility. Limitations on capital. Stronger or weaker directional biases. Whatever the scenario, you have the choice of a logical option strategy that can be risk-defined, capital-effective, and/or have a higher probability of profit than simply buying or shorting stock.
By sorting each strategy into buckets covering each potential combination of these three variables, you can create a handy reference guide. You could even print it out and tape it to your wall. Doing so might help you run through the process of making speedy trading decisions should you need or if warranted.
We’ll help you get started with this list of strategies designed for a high-volatility market environment. Notice how most of them are composed of the basic vertical and calendar spreads. As you review them, keep in mind that there are no guarantees with these strategies. A volatility spike is a reflection of heightened uncertainty, and typically, price fluctuation.
Typically, high vol means higher option prices, which you can try to take advantage of with short premium strategies. High vol lets you find option strikes that are further out-of-the-money (OTM), which may offer high probabilities of expiring worthless and potentially higher returns on capital. Pushing short options further OTM also means that strategies have more room for the stock price to move against them before they begin to lose money. Here are a few bullish, bearish, and neutral strategies designed for high-volatility scenarios.
STRUCTURE: Sell put
CAPITAL REQUIREMENT: Higher
RISK: Technically defined, as a stock can go all the way to zero, but no lower. So while it's defined, zero can be a long way down. See figure 1.
Those with an interest in this strategy could consider looking for OTM options that have a high probability of expiring worthless and high return on capital. Capital requirements are higher for high-priced stocks; lower for low-priced stocks. Account size may determine whether you can do the trade or not. Many traders may look for expiration in the short premium “sweet spot,” typically between 20 and 50 days out, depending on the level of implied volatility, upcoming news or company announcements, among other factors. Targeting the sweet spot aims to balance growing positive time decay with still-high extrinsic value. Choose a stock you’re comfortable owning if the stock drops and short put is assigned. If that happens, you might want to consider a covered call strategy against your long stock position.
STRUCTURE: Sell put, buy lower-strike put of same expiration.
CAPITAL REQUIREMENT: Lower; depends on difference between strikes
RISK: Defined. See figure 2.
Traders consider using this strategy when the capital requirement of short put is too high for an account, or if defined risk is preferred. Traders might target credit for a short vertical around 1/3 of the width of the strikes (i.e. $0.33 if the strikes are $1 apart). Traders commonly consider looking for expiration in the short premium “sweet spot,” again, typically around 20 to 50 days out. Some traders create a short OTM put vertical by looking for OTM put that has high probability (perhaps 65-70%) of expiring worthless, then look at buying further OTM put to try to get the target credit, typically one or two more strikes OTM.
STRUCTURE: Sell call, buy higher-strike call of same expiration.
CAPITAL REQUIREMENT: Lower, but depends on difference between strikes
RISK: Defined. See figure 3.
Some traders look to target the credit of the trade at 30% of the difference between strikes (i.e. $0.30 if the strikes are $1 apart). Consider looking for expiration in the “sweet spot,” typically between 20 to 50 days out. Create by looking for an OTM call that has a high probability of expiring worthless (again, perhaps 65-70%), then look at buying a further OTM call to try to get the target credit, typically one or two strikes further OTM.
STRUCTURE: Buy 1 call, sell 3 higher-strike calls, buy 2 higher-strike calls; strikes equidistant.
CAPITAL REQUIREMENT: Lower; depends on difference between long and short strikes
RISK: Defined. See figure 4.
Combination of a short OTM call vertical and long at-the-money (ATM) or slightly OTM call butterfly. This should be a credit spread, where the credit from the short vertical offsets the debit of the butterfly. This is not aggressively bearish, as max profit is achieved if stock is at short strike of embedded butterfly. But if an unbalanced call butterfly is initiated for a credit, it should not lose money if the stock drops and the options in the position expires worthless.
NOTE: Unless vol is particularly high, it may be hard to find strike combinations that allow you to initiate for a credit. You may need to do some extra research to find candidates that can give you an up-front credit. If instead of a bearish bias, your bias is bullish, you could consider an unbalanced put butterfly, which consists of the same 1-3-2 ratio, only working down from the ATM and in equidistant strikes. Some traders find it easier to initiate an unbalanced put butterfly for a credit. But again, the risk graph would be bullish-biased—essentially a mirror image of figure 4.
STRUCTURE: Sell lower-strike put vertical, sell higher-strike call vertical; distance between long and short strikes same.
RISK: Defined. See figure 5.
Consider targeting the credit to a fixed percentage of the trade, such as 40% of the difference between long and short strikes (i.e. $0.80 or higher in a $2-wide iron condor). Traders generally look for expiration in what some consider to be the the short premium “sweet spot,” typically between 20 and 50 days out, to balance growing positive time decay with still-high extrinsic value. Higher vol lets you find further OTM calls and puts that have high probability of expiring worthless but with high premium. Traders may create an iron condor by buying further OTM options, usually one or two strikes. You might not want to put it on for too small of a credit no matter how high the probability, as commissions on 4 legs can sometimes eat up most of potential profit.
STRUCTURE: Buy 1 lower-strike option, sell 2 higher-strike options, buy 1 higher-strike option; all calls or puts, all strikes equidistant.
CAPITAL REQUIREMENT: Lower
RISK: Defined. See figure 6.
Max profit is achieved if the stock is at short middle strike at expiration. Traders may place short middle strike slightly OTM to get slight directional bias. The probability of profit is usually under 50% due to the narrow profit range of a long butterfly. High volatility keeps value the of ATM butterflies lower. Butterflies expand in value most rapidly as expiration approaches, so traders may look at options that expire in 14 to 21 days. Short gamma increases dramatically at expiration (i.e., increases the magnitude of the options change in value) if the stock is at the short strike. Consider taking profit—if available—ahead of expiration to avoid butterfly turning into a loser from a last-minute price swing.
NOTE: Butterflies have a low risk but high reward. They're often inexpensive to initiate. Some traders would say they’re inexpensive for a reason, which is that maximizing the return from a butterfly requires not only a pinpoint target in the stock price, but also pinpoint timing.
Let’s face it; periods of high volatility can be unsettling. After all, volatility is related to uncertainty, and, where money is concerned, uncertainty can be unpleasant. But if volatility has you feeling like you’ve been handed a bag of lemons, experienced options traders can consider these strategies as a way to try and make some lemonade.
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The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
The covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.
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