Volatility is a key factor for all options 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" is the volatility value calculated by an option pricing model when the actual market price of the option is passed into the model. It can fluctuate based on trader expectations. Essentially, 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.
- When market volatility soars, it can frighten some investors as prices fall and gyrate.
- Options contracts, however, can be leveraged to take advantage of high volatility to profit while others are fearful.
- Here, we look at one such strategy: the put credit spread; and how it can be used to navigate volatile markets.
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 market once again slowly turns higher, implied volatility – and thus the amount of time premium built into stock index options – tends 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 CBOE Volatility Index (VIX). The VIX measures the implied volatility of the options on the ticker SPX (which tracks the S&P 500).
Figure 1 displays the VIX at the top with the three-day relative strength index (RSI) below it, and the ticker SPY (an exchange-traded fund [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 financial instrument that provides opportunities for both hedging and speculation. See Introducing the VIX Options.)
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 they believe 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: an 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."
For timing purposes 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.
(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 break-even 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 percent) over the next 22 days, this trade will show a profit.
Figure 3 displays the risk curves for this trade.
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 their loss.
The Bottom Line
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 their 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 constantly 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, read Understanding Option Pricing.)