If you do not understand implied volatility and you are buying put or call options or some combination, you have been warned!
The market continues to move very fast, has large swings, and one would think that makes it an excellent time to buy options for huge gains, right? Our Research Team believes that large Volatility swings will be here for a while. Once you understand the significant role Volatility plays in Option Pricing, you may want to avoid this investment construct for some time to come.
The VIX is at an extreme level and has only been over 50 only seven times in the past 25 years based on a daily closing price. It evident the last two trading sessions the investment sentiment has been bearish and option puts make money if price declines, which has been the popular trade of choice until now.
What many options traders do not understand, however, is that the price of options is configured using implied volatility.
The more volatility, the more expensive the options become to factor in the wild swings the underlying security may experience. This is reflected in the price the option trades off to factor in the fear and trepidation.
This can be seen in the substantial premium on top of the intrinsic pricing from the strike price.
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For example, bank stocks are usually considered very conservative when implied volatility is under 20. This results in options being priced accordingly.
However, in the last few trading sessions, volatility has jumped, reaching 62 at one point this week already, which is more than 3x what you would want when simply buying options. This is a VERY HIGH RISK and a difficult time to buy options. Unfortunately, this is what most options traders do, they BUY options, and while it may work in most market conditions, this is most likely NOT the time you want to do so until such time Volatility and VIX begin to subside and we do not see that in the near future.
Let me try to explain in the most basic laymen terms because I know 95% of options trades don’t really get this, and it boggles my mind. As you know, or should know, buying options is one of the riskiest and hardest ways to profit from the market, in my opinion (and statistics continue to prove this out as MOST option buyers LOSE money). I traded options years ago and do very little options trading now, though they are still a great way to make money with certain trade setups and in certain market conditions.
OPTIONS RISK #1: TIME DECAY/THETA
In short, trying to time the market with an index, stock, sector, commodity, or currency is hard enough, but when you buy options, you make things a whole lot harder for yourself. Not only do you need to time this almost perfectly so that the underlying asset has time to move, but you need to time it with precision because now the time is your enemy (Theta).
Every day the option contract you bought is going to lose value because you lose time, and there are fewer days left for your asset to move in the direction to make up for the large premium embedded in the option price. Each day this time premium begins to erode. The closer you get to the time expiration, the faster the time premium decays.
OPTIONS RISK #2: IMPLIED VOLATILITY
This is the main issue I want to share and the reason for writing this article for you.
If options are valued in relation to implied volatility (which they are), then when the volatility is above 50 (62 as of Monday, March 9) and the option is worth $1,00.
Here is the issue, even if the price of your asset stays the same, but the fear in the market fades away as it always does from this extreme level, your option value will decline dramatically. I’m just using numbers out of thin air for the example so you can grasp the issues easily.
If implied volatility drops from 62 down to 35, the option contract value will go down with the volatility as well. The $1.00 contract priced with huge volatility could now be worth $0.85 overnight.
If you traded a short-term option contract, then you will also have time decay, and your option would drop even more to say $0.82.
Remember this is the type of price action you will experience and the VIX falling (and fear subsiding) and even if your asset price just stays the same you have the potential for a significant loss and is the reason why buying options during extreme high volatility is not the trade that should be taken.
OPTIONS TRADING TIP
If implied volatility is over 25 then
it is usually better to be a seller of options,
if it’s under 25, then its often better to be a buyer.
So what does a trader do?
We encourage investors to use probabilities to work in your favor!
You could put on debit spreads: This way, some of the volatility is reduced as you sell a put or call, so the volatility premium is now in your favor, and time decay is mitigated.
Sell it to those people that are so sure of this big move!
We have already identified that we are in a period where the VIX in an area very rarely seen. But since the VIX can stay here for a while, a more logical option move may be to sell calls going out into the future. Due to contango, it will retrace back down as the contango effect will begin to change as trader sentiment improves, and fear is reduced.
Credit spreads have so many advantages over simply buying calls and puts
- Defined risk – Can only lose the difference of your strikes less the premium received.
- If the trade starts to go against, you have backup options to manage risk.
- Roll the trade to a future date giving your trade time to work out.
- Sell another option spread opposite of your existing trade (if a put spread on place a credit call spread, this creates an iron condor) now giving you a larger cushion for the trade to work as you received more premium.
- Buyback the offending strike at a loss and let the profitable strike run if you feel it has legs.
- Buy a put to defend your spread further out in time as theta decay does not get affected as quickly.
- Use a stop loss of 2x or 3x premium received etc.
- or take possession of the stock
- Income – selling out of the money credit spreads can be an effective way of generating a passive revenue stream
RISK REWARD is most important, and it is critical to get into the right trade at the right time. Remember that theta-neutral trades and buying options are when implied volatility is low. Selling options, when implied volatility is high, is your best option.
- This is where we are right now.
I hope this helps shed some light on the basics of why buying options during high volatility is an uphill battle, no matter how good your timing is to predict the movement of the underlying asset you are trading.
In the near future, my team and I will make our options trades available to follow. As you know, timing the market is our specialty. Knowing what time frame an asset will rally or breakdown, and how far its first move will give us a distinct advantage to pinpoint the ideal option contracts to consider buying or selling for maximum short-term gains.