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Zeroing In On a Strategy

December 21st, 2012
in contributors

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

As I wrote last week, the three things that change option prices are: underlying price change, the passage of time, and changing implied volatility. We have to bet on at least one of them, and be right, to make money. Betting on time passing alone won’t do it. There is no risk that time will not pass (except to theoretical physicists), so using options to bet that it will does not pay very much. It only pays us, on average, what we could make in T-bills (the risk-free interest rate). No risk, no reward. With time alone eliminated as a profit center, we need to concentrate on one (or both) of the other two – price or volatility. This week we’ll go through the process of developing our opinion, and then selecting a strategy to match.

With options, uniquely, we can decide which of the two profit centers (price or volatility) we want to concentrate on, and just how sure we are of our opinion. We don’t have that choice in stocks, or Forex, or futures, whose only dimension is price.

Follow up:

Not only that, options also give us the ability to bet against up, down or sideways. Betting that a stock’s price will not go down is not the same as betting that it will go up. If we bet that it will not go down, then price helps us if it goes up or if it goes nowhere (sideways). Both of those are instances of not going down. We could also bet that a stock’s price will not go up, or that it will not go sideways.

In last week’s article, I showed a price/volatility decision matrix, which is reproduced here:

I Think Price Will:

I Think IV Will:

Rise

Rise

Fall

Stay the Same

No Opinion

Fall

Rise

Fall

Stay the Same

No Opinion

Stay in a Range

Rise

Fall

Stay the Same

No Opinion

Move out of a Range

Rise

Fall

Stay the Same

No Opinion

No Opinion

Rise

Fall

Stay the Same

No Opinion

 

Now that we’ve laid out this array of choices, let’s see how we would go about using them to look for an option trade opportunity in the real world. We’re going to need a stock or ETF where we have a clear opinion on either price, or implied volatility, or both.

The easier one to get a handle on is implied volatility (IV). This is because it tends to stay in a range, and snap back to its average after it does move away from it, more reliably than price. This allows us to determine whether IV is currently high (and therefore expected to drop) or low (and expected to rise), compared to its average over recent history.

The measure for the general environment for IV of stocks in the U.S. is the implied volatility of the S&P 500, also called the VIX. As of this writing, the VIX was around 15%.  Over the last year, the VIX has ranged from 12% to 30%. At 15%, it’s much closer to the bottom than to the top of this range.  We’d say that the VIX is low, and therefore more likely to rise than to fall. It certainly could fall even further – it’s just less likely.  Everything about options is an exercise in probability.

What’s true of the S&P 500 regarding IV, is also true of most individual U.S. stocks, as well as most ETFs (since the ETFs are mainly various baskets of stocks). If we were to bet on volatility to decrease on any individual stock or ETF, we’d be betting on it to buck the tide of the market. So we’d be better off betting that IV would rise or stay the same.

This knocks out half of our price/volatility decision matrix. We’ve eliminated all of the combinations that include the expectation that volatility will decrease. Since volatility it quite near the bottom of the range, we can also eliminate the “No opinion” column.  That’s the one we’d use if IV was quite close to the middle of the range.

With our bias toward an increase in volatility in mind, let’s look at a particular ETF whose IV is also very low based on its own historical range.  We find that XLF, the ETF for financial stocks, is at an IV of 17%. This is at the lowest level in several years. In the last year XLF’s IV has ranged from 17% to 48%. We’d have to conclude that for this specific ETF, we’d expect IV to increase. That would be in line with our expectation that the S&P’s IV is likely to increase or stay the same.

What about XLF’s price? It has been in a strong uptrend-within-an-uptrend for the last month, and at $16.14, it’s now closing in on its post-Crash high of $16.44. Price could fail near that old high if there is still enough supply (orders to sell) at that level. In that case the recent low of this mini-uptrend around $15.00 would be within range.  On the other hand, since that high was made last September, it has been retested four times, including this one. It is quite possible that the high is “worn out” (most old sell orders at that level already filled), and that price could move on through and break out to new highs.  The one thing that is quite unlikely is for price to hover at this level for an extended period. So  from our price/volatility decision matrix, we can select “Move out of a range” as the most likely path for price.

That makes our choice from the decision matrix the combination of “I expected price to move out of a range” and “I expect volatility to increase.”  What strategies would that translate to?

First, we know that it will involve buying options rather than writing them (selling them short). This is because of our expected increase in volatility. Increasing IV pushes upward on the prices of all options, both puts and calls. This helps option owners, and hurts option writers. Secondly, since we think price could move in either direction (and since we already know that we’ll be option buyers), we know that we’ll be buying both calls and puts.

What strategies fit these descriptions?  Here are the common ones:

Straddles – buying at-the-money puts and calls simultaneously

Strangles – buying out-of-the-money puts and calls simultaneously

Each of these strategies benefits from a rise in volatility and/or from a sizable move in price. Next week we’ll drill down into the differences between these two strategies, to see why we would choose one of them over the other.

A note: "If you have questions or comments on this article, please contact me at rallen@tradingacademy.com."

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