Trading options in volatile markets
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How to use volatility in trading
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There are seven factors or variables that determine the price of an option. Of these seven variables, six have known values, and there is no ambiguity about their input values into an option pricing model.
But the seventh variable—volatility—is only an estimate, and for this reason, it is the most important factor in determining the price of an option. Volatility can either be historical or implied; both are expressed on an annualized basis in percentage terms. Historical volatility is the actual volatility demonstrated by the underlying over a period of time, such as the past month or year.
Implied volatility IV , on the other hand, is the level of volatility of the underlying that is implied by the current option price.
Volatile Markets Made Easy: Trading Stocks and Options for Increased Profits
Think of implied volatility as peering through a somewhat murky windshield, while historical volatility is like looking into the rearview mirror. While the levels of historical and implied volatility for a specific stock or asset can be and often are very different, it makes intuitive sense that historical volatility can be an important determinant of implied volatility, just as the road traversed can give one an idea of what lies ahead. All else being equal, an elevated level of implied volatility will result in a higher option price, while a depressed level of implied volatility will result in a lower option price.
For example, volatility typically spikes around the time a company reports earnings. Two points should be noted with regard to volatility:. The most fundamental principle of investing is buying low and selling high, and trading options is no different. Based on this discussion, here are five options strategies used by traders to trade volatility, ranked in order of increasing complexity.
This strategy is a simple but expensive one, so traders who want to reduce the cost of their long put position can either buy a further out-of-the-money put or can defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread. Note that writing or shorting a naked call is a risky strategy, because of the theoretically unlimited risk if the underlying stock or asset surges in price.
In order to mitigate this risk, traders will often combine the short call position with a long call position at a higher price in a strategy known as a bear call spread. In a straddle , the trader writes or sells a call and put at the same strike price in order to receive the premiums on both the short call and short put positions. The rationale for this strategy is that the trader expects IV to abate significantly by option expiry, allowing most if not all of the premium received on the short put and short call positions to be retained.
Writing a short put imparts on the trader the obligation to buy the underlying at the strike price even if it plunges to zero while writing a short call has theoretically unlimited risk as noted earlier. However, the trader has some margin of safety based on the level of the premium received. A short strangle is similar to a short straddle, the difference being that the strike price on the short put and short call positions are not the same.
As a general rule, the call strike is above the put strike, and both are out-of-the-money and approximately equidistant from the current price of the underlying. In return for receiving a lower level of premium, the risk of this strategy is mitigated to some extent. Ratio writing simply means writing more options that are purchased. The simplest strategy uses a ratio, with two options, sold or written for every option purchased.
The rationale is to capitalize on a substantial fall in implied volatility before option expiration. In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the same expiration, hoping to capitalize on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options.
The iron condor is constructed by selling an out-of-the-money OTM call and buying another call with a higher strike price while selling an in-the-money ITM put and buying another put with a lower strike price. Generally, the difference between the strike prices of the calls and puts is the same, and they are equidistant from the underlying. You still keep the premium money you received, and you have no obligation regarding the stock. Either way, whether the stock goes up or down, you win.
You either buy the stock you like at the price you want, offset by the premium you received for the put. Or, you simply keep the premium. The downside is limited, though of course so is the upside.
Volatile Markets: Strategies That Can Make Killings
With a bull put spread, you sell a put short with a higher strike price, and simultaneously buy a put with a lower strike. Selling the put at a higher strike provides income, while buying the lower strike put protects against a decline in the stock. The maximum profit using this strategy is the net credit. This is the difference between what you received for writing selling the put, and the amount used to purchase the put with the lower strike.
If the stock price ends up higher than the higher strike, the option expires worthless, and you keep the net premium you received. This is the best case scenario. The break-even point occurs when the stock price lands lower than the higher strike short put, by an amount equal to the net credit received. In the worst case, the price drops below the lower strike price. Here the investor has to buy the stock at the higher strike price and sell it at the lower price.
Therefore, the maximum loss is the difference between the strike prices, less the net credit received. Investors think it will rise a bit in a month. This is the maximum loss, no matter how the stock performs. Writing puts allows you to keep the premium you collect. Or, buy a stock you like at a price you like, in addition to keeping the premium. A put spread protects against a stock drop, but allows you to profit from a stock price rise as well.
Both profit and loss on this trade are limited. In the case of the spread, the net income is also your maximum profit. Choose wisely, remembering that you might have to pay money out if the stock drops below your lower strike put. Which option you choose is up to you. If we use yours as a SteadyDime recommendation we will give you one free month to our put selling program.
Best Option Trading Strategies in Volatile Market Condition
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