3 Ways to Play Volatility with Options

By MoneyShow.com | November 16, 2011 AAA

With the VIX spiking above the important 30 level, traders can choose from three distinct strategies that sell (and buy) premium and would profit from changes in option volatility.

The CBOE Volatility Index (VIX) and associated ETNs like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), which measure the implied volatility of S&P 500 Index (SPX) (SPY) options, shot up quite a bit this past week. With the headline risk from Europe affecting global stock markets, the VIX closed at 36.16, back above the key 30 level.

One rule of thumb regarding the VIX is that it measures the expectation priced into options for the potential movement of the SPX over the next 12 months (based on one month of option pricing). So a VIX of 36 means that SPX option traders/market makers are pricing that the SPX could move up or down 36% over the next 12 months—quite a high volatility level on both an historical and a real basis, in my view.

Remember that for every option purchase, there is a corresponding option sale; so with implied volatilities high (which, combined with time value, comprise the premium in option prices), let’s take a look at the basics of some option trading strategies that incorporate option selling. This way you can have a portion of your portfolio that receives time decay and can benefit from volatility going down.

Here are a few strategies that will allow you to sell implied volatility/option premium, as well as buying it:

Selling Covered Calls/Covered Puts

The simplest of these three strategies, this is basically selling an out-of-the-money (OTM) call against a long stock position you may own. This can be done at the time of the stock purchase (buy/write), or against an existing stock position (to protect gains and/or lower cost basis).

On the flip side, against a short stock position, you can sell an out-of-the-money "covered put." In both of these situations, you end up collecting a credit for selling an option, putting yourself short time premium and implied volatility.

The tradeoff for receiving a credit and lowering your cost basis is that you will limit your potential upside gain to the strike you sold. You will receive the benefit of time premium decay ("Theta") and also potentially gain if the implied volatility on the option you sold comes down.

See related: Know Your Option “Greeks”

Credit Spreads

Without going into too much depth, a credit spread (also known as a "vertical bull or bear spread") involves selling an option and buying another option of the same stock in the same expiration month, but of a different strike.

Normally on a credit spread we would be selling an at-the-money (ATM) or OTM strike and buying a further-out strike. So, for example, a bearish December credit spread on XYZ stock (with XYZ shares at $52) might be to sell the December 55 call while simultaneously buying the December 60 call.

You will receive a credit for selling this five-point spread due to the premium on the 55 call being much higher than the 60 call. You then theoretically will receive time decay on the position as it approaches expiration, assuming the stock goes down, stays even, or even rallies a bit because the 55 call will lose time premium at a more rapid rate than the 60 call. You also should benefit if the stock’s volatility and/or the option implied volatility drops.

See related: Understanding Time Decay in Options

NEXT: A Strategy for More Advanced Traders

Horizontal Calendar Spreads

The most advanced of the strategies I’m discussing today is the calendar spreads. This involves trading an option in the front or second month, for example, and hedging with an option of the same stock, same strike, but in a further-out expiration month. The further-out option can be as far out as LEAPs out a year or two ahead.

A calendar spread can in effect be a "Vega" trade, but it can also be done as a Theta collection trade. The far-out options are basically all Vega, so if you are banking on implied volatilities coming down, you would be looking at buying the front- or second-month option and selling the further-out option, such as a LEAP.

The reason for this is that the implied volatility portion, or Vega, of the further-out option is much higher than the closer expiration. So, even though the Theta, or time decay, of the closer option will decay at a faster rate, a decline in implied volatilities will be more magnified on Vega in the back-month options.

Another simpler version of a calendar spread would be to flip this around by selling a front month as it approaches expiration and buying a second month in order to collect the rapid time decay of the final two weeks heading into Expiration.

These kinds of strategies are fairly complex and should be evaluated in an options position analytic software of some sort (most option brokers offer these in their trading platforms nowadays). In addition, you will want to track how the further-out implied volatilities move in relation to the front months, as they will not move at the same rate.

If you are interested in trading these kinds of advanced options strategies and more, you will generally need a margin account with your brokerage house, as well as the proper options trading approval to trade a variety of option strategies. Contact your broker for more info.

And as I mentioned, I am just touching on the basics of these multi-leg advanced trading strategies. There are many other strategies where you can benefit from moves in implied volatility and receive time decay, such as diagonal spreads, ratio spreads, butterflies, iron condors, etc.

By Moby Waller of BigTrends.com

The two advanced strategies that we utilize most often in our BigTrends newsletters are debit spreads (in ETF TRADR) and diagonal spreads (in SMART Options). We have research "white papers" available at no cost on these two specific strategies. If you are interested in more information about these trading programs or option/trading education in general, please contact us at 1-800-244-8736.

You May Also Like

Related Analysis
  1. Stock Analysis

    Bear of the Day: PHH Corp (PHH) - Bear of the Day

  2. Stock Analysis

    Bull of the Day: Rite Aid (RAD) - Bull of the Day

  3. Stock Analysis

    Merck Up on OncoEthix Acquisition Deal, Oncology in Focus - Analyst Blog

  4. Stock Analysis

    ALLETE Buys NRG Energy's Storm Lake 1 Iowa Wind Farm - Analyst Blog

  5. Stock Analysis

    Starwood Expands in Colombia with Four Points by Sheraton - Analyst Blog

Trading Center