Option Volatility Trading
There are many ways to play the volatility game with option volatility trading. Like many other situations in options there are at least two ways to play. You can use some of these strategies if volatility is low and you expect it to go higher, or use other strategies if volatility is high and you expect it to go lower.
Trading Option Straddles and Option Strangles
The Long Straddle is a delta neutral strategy best placed in a market with high historical volatility at a time when the implied volatility is low and where you anticipate a volatility increase. Purchase an equal numbers of ATM Puts and ATM Calls with 45 days or more until the same expiration date.The Long Strangle is a delta neutral strategy best placed in a market with high historical volatility at a time when the implied volatility is low and where you anticipate a volatility increase. Purchase an equal numbers of OTM Puts and OTM Calls with 45 days or more until the same expiration date.
This strategy is similar to a Straddle. It is less expensive to open, but takes a large price move to reach the break-even prices. Both of these trades are examples of option volatility trading.
Entry Rules
Price consolidation usually visible as tightening Bollinger Bands on a stock chart.
Cheap options - Low Implied Volatility compared to Historical Volatility
Additional Criteria that improve probability of success:
Scheduled earnings announcement or upcoming event. History of price movement with news or earnings announcements. Buy 3-4 weeks before announcement when option prices are low, because option prices go up as the announcement date gets closer due to increased volatility, even without the stock price changing.
Exit Rule Insights
Exit 30 days prior to expiration if there has been no movement in the underlying asset.
Exit just before or after the earning announcement, depending on the history of the stock’s movement on prior earnings announcement dates. If a stock has made a good move in anticipation of the news, consider getting out of the profitable option the day before. Many times the stock will move in the opposite direction, no matter what the news is because people are ‘buying on the rumor, and selling on the fact’.
Exit at a profit target of 50% of the entire trade (the cost of the Call + the cost of th Put).
Exit if there is a big move in the underlying asset soon after you enter the position, even if the date for the ‘news’ has not happened yet.
Profit & Loss Calculations for the Option Straddle
Maximum Risk – Limited to the net debit paid
Maximum Profit – Unlimited to the upside and downside beyond the breakeven prices
Upside breakeven – ATM Call strike price + net debit paid
Downside breakeven – ATM Put strike price - net debit paid
Profit & Loss Calculations for the Option Strangle
Maximum Risk – Limited to the net debit paid
Maximum Profit – Unlimited to the upside and downside beyond the breakeven prices
Upside breakeven – Call strike price + net debit paid
Downside breakeven – Put strike price - net debit paid
Trading Option Calendar Spreads
Calendar Spreads used for option volatility trading can be traded with either Calls or Puts depending on your intermediate term outlook for an underlying asset. In either case, you are looking for stable markets, preferably one that is in a trading range.The Call Calendar Spread is an options trading strategy best used in trading range markets. Buy one long term Call with 90 days or greater until expiration and sell one short-term Call with 45 days or less until expiration at same strike price. This trade is normally done ATM or slightly OTM. The objective of this trade is to capture time decay since the sold Call will lose value faster than the purchased Call. Repeat sale of another short-term option if time permits against long term Call to capture additional time premium. Hold long Call if market looks ready to break out in an upward direction.
Entry Rules
Stocks expected to stay in a trading range. Implied Volatility Skews of sold Call at least 15% greater than purchased Call. Buy as much time as you can while keeping the net debit of the spread under $2 per contract.
Exit Rule Insights
Hold position until expiration week of the sold option.
If the options are ITM: roll forward to the next month - buy back the Call option you sold and sell the next month’s Call option at the same strike price.
If the options are OTM: let the current month options expire worthless. Sell the next month’s Pall option on the Monday following expiration.
If the options are ATM you have several options:
- Sell the option you purchased to close out the spread.
- Roll forward to continue the position,
- Convert the position to a Bull Call spread or Bear Call spread, depending on your outlook for the underlying asset.
If the option you purchased is entering its final month before expiration, close the position, or keep the Call or convert to a Bull Call spread if you are now Bullish on the underlying asset.
Profit & Loss Calculations for Call Calendar Spread
Maximum Risk – Limited to the net debit paid for the spread
Maximum Profit – Unlimited at short-term Call expiration
Breakeven – Strike price + net debit paid after short-term Call expiration
The Put Calendar Spread is an options trading strategy best used in trading range markets. Buy one long term Put with 90 days or greater until expiration and sell one short term Put with 45 days or less until expiration at same strike price. This trade is normally done ATM or slightly OTM. The objective of this trade is to capture time decay since the sold Put will lose value faster than the purchased Put. Repeat sale of another short-term option if time permits against long term Put to capture additional time premium. Hold long Put if market looks ready to break out in an downward direction.
Entry Rules
Stocks expected to stay in a trading range. Implied Volatility Skews of sold Put at least 15% greater than purchased Put. Buy as much time as you can while keeping the net debit of the spread under $2 per contract.
Exit Rule Insights
Hold position until expiration week of the sold option.
If the options are ITM: roll forward to the next month - buy back the Put option you sold and sell the next month’s Put option at the same strike price.
If the options are OTM: let the current month options expire worthless. Sell the next month’s Put option on the Monday following expiration.
If the options are ATM you have several options:
- Sell the option you purchased to close out the spread.
- Roll forward to continue the position,
- Convert the position to a Bull Put spread or Bear Put spread.
If the option you purchased is entering its final month before expiration, close the position, or keep the Put or convert to a Bear Put spread if you are now Bearish on the underlying asset.
Profit & Loss Calculations for Put Calendar Spread
Maximum Risk – Limited to the net debit paid for the spread
Maximum Profit – Unlimited at short-term Put expiration
Breakeven – Strike price - net debit paid after short-term Put expiration
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