Volatility is a key factor for all option traders to consider. The volatility of the underlying security is one of the key determinants regarding the price of the options on that security. If the underlying security is typically volatile in terms of price movements, then the options will generally contain more time value than they would if the stock was typically a slow mover. This is simply a function of option writers seeking to maximize the amount of premium they receive for assuming the limited profit potential and excessive risk of writing the option in the first place.
Likewise, "implied volatility" – the volatility value calculated by an option pricing model when the actual market price of the option is passed into the model – can fluctuate based on trader expectations. In a nutshell, a rise in volatility causes the amount of time premium built into the options of a given security to rise, while a decline in volatility causes the amount of time premium to fall. This can be useful information for alert traders.

Fear and the Stock Market
Generally speaking, the stock market tends to decline swiftly during a downturn – as fear triggers a flurry of sell orders – and to rally more slowly. While this is not always the case, of course, it is a reasonable rule of thumb. As such, when the stock market starts to fall, option volatility tends to increase – often rapidly. This causes option premiums on stock indexes to rise even beyond what would normally be expected, based solely on the price movement of the underlying index itself. Conversely, when the decline finally abates and the stock market once again slowly turns higher, implied volatility – and thus the amount of time premium built into stock index options – tend to decline. This creates a potentially useful method for trading stock index options.

The most common gauge of "fear" in the stock market is the VIX Index. The VIX measures the implied volatility of the options on the ticker SPX (which tracks the S&P 500). Figure 1 displays the VIX Index at the top with the three-day Relative Strength Index (RSI) below it, and the ticker SPY (an ETF that also tracks the S&P 500) at the bottom. Notice how the VIX tends to "spike" higher when the SPX falls. . (Discover a new financial instrument that provides great opportunities for both hedging and speculation. See Introducing The VIX Options.)

Figure 1 – The VIX Index (top) tends to "spike" higher when the S&P 500 falls
Source: ProfitSource by HUBB

The Put Credit Spread
When the stock market declines, put prices typically increase in value. Likewise, as implied volatility concurrently rises as the stock index falls, the amount of time premium built into put options often increases significantly. As a result, a trader can take advantage of this situation by selling options and collecting the premiums when he or she believes the stock market is ready to reverse back to the upside. As selling naked put options entails the assumption of excessive risk, most traders are rightly hesitant to sell naked puts, particularly when there is negative sentiment overriding the market. As a result, there are two things to help in this situation:

  • Some indication that the selloff is abating or will soon abate, and
  • The use of a credit spread using put options.

Taking the second point first, a put credit spread – also commonly known as a "bull put spread" - simply involves selling (or "writing") a put option with a given strike price and simultaneously buying another put option at a lower strike price. Buying the lower strike price call "covers" the short position and puts a limit on the amount of money that can be lost on the trade.

Determining when the stock market is going to reverse is of course the long sought after goal of all traders. Unfortunately, no perfect solution exists. Nevertheless, one of the benefits of selling a bull put spread is that you do not necessarily have to be perfectly accurate in your timing. In fact, if you sell an out-of-the-money put option (i.e., a put option with a strike price that is below the current price of the underlying stock index), you only need to "not be terribly wrong." An example will illustrate this momentarily.

For timing purpose we will look for three things:

  • SPY is trading above its 200-day moving average.
  • The three-day RSI for SPY was at 32 or below.
  • The three-day RSI for VIX was at 80 or higher and has now ticked lower.

When these three events take place, a trader might consider looking at put credit spreads on SPY or SPX. (Another useful trading strategy involves hedging iron condors with put calendars to help control losses, and can even make an investor more profitable. For further reading, refer to Find Profits By Hedging Iron Condors.)

Let's look at an example using the signals in Figure 1. On this date, SPY stood above its 200-day moving average, the three-day RSI for SPY had recently dropped below 32 and the three-day RSI for the VIX had just ticked lower after exceeding 80. At this point, SPY was trading at 106.65. A trader could have sold 10 of the November 104 puts at $1.40 and bought 10 of the November 103 puts at $1.16.

As you can see in Figures 2 and 3:

  • The maximum profit potential for this trade is $240 and the maximum risk is $760.
  • These options have only 22 days left until expiration.
  • The breakeven price for the trade is 103.76.

To look at it another way, as long as SPY falls less than three points (or roughly -2.7%) over the next 22 days, this trade will show a profit.

Figure 2 – SPY November 104-103 Bull Put Credit Spread
Source: ProfitSource by HUBB

Figure 3 displays the risk curves for this trade.

Figure 3 – Risk curves for SPY Bull Put Credit Spread
Source: ProfitSource by HUBB

If SPY is at any price above 104 at expiration in 22 days, the trader will keep the entire $240 credit received when the trade was entered. The maximum loss would only occur is SPY was at 103 or less at expiration. Should SPY drop below a certain level a trader might need to act to cut his or her loss.

In this example, the rise in implied option volatility prior to the signal date – as measured objectively using the VIX index – served two purposes:

  • The spike in the VIX and the subsequent reversal was an indication of too much fear in the market – often a precursor to a resumption of an ongoing uptrend.
  • The spike in implied volatility levels also served to inflate the amount of time premium available to writers of SPY options.

By selling a bull put credit spread in these circumstances, a trader is able to maximize his/her potential profitability by taking in more premiums than if implied volatility was lower. The method described here should not be considered as a "system," and certainly is not guaranteed to generate profits. It does however serve as a useful illustration of how combining multiple factors can lead to unique trading opportunities for option traders.

This example involved combining the following factors:

  • Price trend (requiring SPY to be above its long-term average)
  • High volatility (a spike in the VIX Index)
  • Increased probability (selling out-of-the-money options)

Traders should be ever vigilant for opportunities to put as many factors – and thus, the odds of success – as far in their favor as possible. (Take advantage of stock movements by getting to know these derivatives. For more information, read Understanding Option Pricing.)

Related Articles
  1. Chart Advisor

    ChartAdvisor for November 27 2015

    Weekly technical summary of the major U.S. indexes.
  2. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  3. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  4. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  5. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  6. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  7. Chart Advisor

    ChartAdvisor for November 20 2015

    Weekly technical summary of the major U.S. indexes.
  8. Chart Advisor

    Is This The Beginning Of A Downtrend In Home Builders?

    Falling lumber prices and weakness on the charts of home builders suggest that the next leg of the trend could be downward.
  9. Options & Futures

    Understanding The Escrow Process

    Learn the 10 steps that lead up to closing the deal on your new home and taking possession.
  10. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  1. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  2. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  5. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  6. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center