The markets continued to rise this week, with the S&P 500 breaking through to multi-year highs. This strong move has subsequently led to the continued fall, finishing right around 12. While things presently support the bulls, I think a healthy dose of caution is warranted in the present market. The VIX making a strong move back above 13 would be a bearish sign.

However, market sentiment aside, the beauty of options volatility trades is that they can profit in a wide variety of market conditions. (If all of this seems too complex, get started with Options Basics.)

Calendar Spread
Calendar spreads take advantage of the difference in decay rates. Options premiums decay at the fastest rate in their last month. By selling the front month strike against the same strike in the next (or subsequent) month, you take advantage of the difference in decay rates.

In Greek terms, the front month has a greater theta, and so the trade itself has a positive theta. It is often possible to find options where the front month also has a higher implied volatility than the next month, and these offer the best opportunities.

Furthermore, calendar spreads have a positive vega, meaning that they benefit from an increase in volatility. Therefore finding stocks with generally low implied volatility is important.

Today's calendar spread is Amazon (Nasdaq:AMZN). The stock is right around $45 and earnings are released on April 24, after April options expiration. Implied volatilities tend to rise into expiration and then drop off sharply after the announcement. This is the especially the case with certain stocks, and Amazon is one of them.

This calendar spread therefore utilizes the May and July options. At the $45 strike, the May ATM (at the money) implied volatilities (IVs)are roughly 40%, while the July IVs are roughly 32%. This is a 25% differential, which is very good.

While the 30-day historical volatility is 23%, the implied volatility has spent most of the last year above 30%, and the historical volatility has jumped as high as 80% after the earnings announcement.

The trade therefore can profit in several ways:
-- The first is for the implied volatilities to rise further into earnings. As the spread has a positive vega, this should produce gains.
-- The second is the collapse of the volatilities after the earnings announcement. The May IVs should drop substantially, but the July IVs probably will as well. This is where the IV differential can make the difference.

The entire spread can be exited just before the earnings announcement. Alternatively, the May options can be bought back right before the earnings announcement and the July held, with the expectation that the stock move will be enough to offset the drop in IV.

Calendar Back-Spread
Today's iron condor/butterfly could be Intuitive Surgical Inc. (Nasdaq:ISRG), as the April IVs are above 90%, some of the highest levels of the year, while the historical volatility is 24%.

However the earnings announcement is the same day as expiration, and the April/May IV differential (skew) is very significant. This calls for a more advanced strategy. A calendar spread would be one choice, but research shows that the IV tends to drop but that real volatility tends to jump, with the stock making 10 or 20 point moves. The would cause a straight calendar spread to lose.

So to take advantage of the IV differential as well as the potential large underlying move, a calendar back-spread can be utilized. The trade will profit from stock moves in either direction, especially if the May IVs hold up. Either the puts or the calls can be used, depending on your outlook.

With the stock at roughly $125, the April $120 call has an IV of 99% and a price of $8.80. The May $135 calls have an IV of 48% and a price of $3.90. By buying two of the May $135 calls for every April $120 call sold, a credit of $1.00 is created. Significant moves in either direction should create a profit.

The criteria for all of these buying strategies are basically the same. You are looking for cheap options. This means different things to different people. Some people look at the price alone. This is a mistake with options.

Inexpensive options are not necessarily a good value. Value is determined by the level of the implied volatility and the historical volatility. Some people just look at the ratio of the two. It is also important to look at the current implied volatility level to the recent range of implied volatilities.

When simply buying options, it is important to keep your time frame in mind. Because of the rapid decay of options in their last month, you do not want to buy options in their last month and hold them for any length of time. Therefore it makes the most sense to buy options with at least three months left until expiration.

Imclone Systems (Nasdaq:IMCL) is a good buying opportunity. The August ATM IVs are roughly 37%. This is one of the lowest levels of the year. The historical volatility is 48%, which presents one of the very few times that the HV is above the IV for Imclone.

With the stock at $41.60, the $40 strike straddle can be purchased for $7.25. To make the trade delta neutral, more puts need to be bought than calls. Another alternative is to buy the $45/40 strangle. A significant move in either direction and/or a significant rise in implied volatility will produce profits. Make sure to exit the trade with or without gains with four to six weeks remaining, as that is when decay increases the most.

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

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  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Equity

    The value of an asset less the value of all liabilities on that ...
  6. Derivative

    A security with a price that is dependent upon or derived from ...
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