When stocks make big moves, volatility spikes. Understanding how to capitalize on volatility using options can give you a trading edge.
Every time you take an options position, you are taking a position on volatility. A move in volatility can be as beneficial or detrimental to your portfolio as a move in the underlying stock price.
Volatility is a combination of both the price change of an asset and the velocity of that change over time. In trading, there are two measures for volatility: historical volatility and implied volatility.
When we look backwards over how volatile a stock has been in the past, it’s a look at historical volatility. When looking forwards to how a stock is expected to move in the future, it’s a measure called implied volatility. Understanding how implied volatility affects options prices is critical to your success as an options trader.
Let’s take a look at how you can build an options trading strategy around volatility.
Discover how Market Rebellion uses the power of unusual option activity to follow the “smart money” and learn how you can conquer any market like a pro. Check out our Insider’s Guide to Trading UOA.
Options and Volatility
Options prices increase when implied volatility expands (all else being equal). Conversely, option prices decrease when implied volatility (or IV) contracts. That’s because higher IV implies a larger move is expected from the underlying stock, adding uncertainty… and uncertainty costs more.
Although options prices are elevated during highly volatile times, we know that volatility is mean reverting. In other words, periods of high volatility are typically followed by low volatility. That trend is reflected historically in the CBOE Volatility Index (^VIX) . When volatility cools down, the asking price for options will inevitably decrease as their movements become more predictable.
All of this translates to options prices with a measure called Vega. Vega measures the change of an options price for every 1% move in the underlying stock’s implied volatility. A move higher in Vega ultimately produces higher options prices, all else equal. The opposite is also true.
How does this translate to options positions? If you’re net long calls or puts, you’re essentially long volatility. On the other hand, if you’re net short calls or puts, you’re short volatility.
Strategies for Trading Volatility
There are plenty of strategies available for trading volatility. Many involve going short to “collecting premium” by selling call or put options while volatility is high. That way if (or when) volatility mean reverts, you’d expect to collect a net profit for taking on the trade.
Selling options when volatility is high is a great way to capture profit from the elevated prices.
However, shorting options outright is too risky for us at Market Rebellion. We don’t recommend that anyone short an option. The risk is simply too high (in the case of shorting calls, it’s unlimited). Instead, you could initiate a credit spread (sell an option, but buy an option further out-of-the-money) that collects a net credit upfront, while limiting your risk.
But let’s say you expect volatility to continue higher. You could take a directional play and go long volatility by purchasing an option or initiating a debit spread.
Long volatility strategies
The easiest and most obvious way to go long volatility is to simply buy calls and puts. If you believe volatility will continue higher and options prices continue to expand, buying an option in the direction of the underlying trend is one way to ride the wave.A bull call spread is another way to be long volatility, but with limited exposure. It means purchasing a long call with a lower strike while simultaneously shorting a call with a higher strike price of the same expiration. This trade results in a net debit and increases in value as the underlying stock price rises. Max gain is the difference between the long and short call.A bear put spread is the exact opposite of a bull call spread and occurs on the put side of the options chain. It consists of one long put at a higher strike and one short put at a lower strike with the same expiration date. The trade also results in a net debit and increases in value as the underlying stock price declines. These vertical spreads allow you to be long volatility, but less long than if you simply bought an option. It’s a great way to mitigate your volatility exposure. You’re less susceptible to a sudden drop in Vega, also known as “volatility crush” — which could be very painful if you’re only long options when they quickly lose value.The long straddle might be the most classic long volatility play. It involves buying a call and put at the same strike price and expiration. These are typically initiated at-the-money and produce a profit if the stock makes a big move either up or down. It’s a useful strategy if you’re looking to be long volatility, but unsure of the specific direction the underlying asset might move.A long strangle is an options trading strategy that is neutral on the direction of the stock. It requires simultaneous buying of a slightly out-of-the-money call and slightly out-of-the-money put of the same expiration. Strangles are similar to straddles, but can be had for a cheaper price since both sides of the spread reside OTM. They become profitable in an extremely volatile environment when the stock moves significantly in either direction. Be careful though: if the stock doesn’t make a large enough move and IV drops, both the call and put could lose value quickly.
Short volatility strategies
Selling covered calls is a way to short options against stock you already own. You collect premium up front by giving someone the option to buy your shares at the strike price. If the options expire in-the-money, you would be forced to sell shares.A bear call spread involves selling a call option at one strike while buying another call at a strike further out-of-the-money with the same expiration. In this strategy, the long call acts as protection in the event the underlying stock price moves higher than anticipated.The bull put spread performs a similar function, just on the put side of the chain. They entail selling a put option at one strike and buying a put option a lower strike. The long put provides you with insurance in the event the underlying price moves too low. Max gain for both types of short vertical spreads is equal to the net credit received upon initiating the trade. It’s achieved when both legs of the spread expire worthless. The risk for each is the difference between the long and short strike prices minus the upfront premium received.An iron condor is another choice for traders looking to collect premium. For this strategy, you would combine a bear call spread and bull put spread for a net credit. The idea being that you believe the stock will stay within the range of both short strikes by expiration.You might also consider a butterfly spread. A long butterfly requires four legs and results in a net debit. It’s considered a neutral trading strategy. For both call and put butterflies, a trader would go long an in-the-money option, short two contracts at-the-money of the same strike, and go long a fourth contract further out-of-the-money (which acts as protection against the short options). All of the options strikes are equidistant to each other. Butterflies work best when the stock price moves sideways and the underlying stock expires at your at-the-money strikes at expiration. If that happens, your long in-the-money option has max value relative to the short option, which expire worthless.
The options for trading volatility are almost limitless. Take note of the market conditions and choose your strategy wisely.
The Bottom Line
Understanding how to utilize the power of options to effectively trade volatility is one of the most important lessons you can learn as a trader. It can help you to trade any market with confidence.
So, decide which options strategies for volatility work best for you. Then you’ll be ready for the next time the VIX surges higher.
Ready to start trading? Try Unusual Option Activity Essential. Learn how you can follow the “smart money” with a fresh UOA trade idea each week – including technical levels so that you know how to manage each trade!