Navigating the Sea of Volatility with Options

When we look through the lens of volatility and where the broad indices are today, we find volatility to be excruciatingly low and stock price charts to appear to be extended. This is not to say that the market cannot extend much higher or that the market will go down in coming months. As an options trader, we are faced with making decisions about events in the future. Which direction could volatility go? What is the primary trend in the broad markets? These questions have to be answered every day and for every trade.

Yesterday’s volatility remained low. The main consensus among many options pundits and experts is that volatility can only go higher over the long-term time frame. While they may be right or wrong, option traders need to be prepared to take action. As of yesterday, broad volatility was a teenager and volatility levels this low, ironically, represent risk to options traders. Option traders considering selling option premium run the risk of higher volatility in the future, which would hurt their positions. Traders considering buying option premium run the risk of adverse price movements, as many charts seem overbought but irrationality can push prices even higher.

What option strategies work in this environment? There are several that can produce outsized gains while mitigating the potential for future volatility increases.

Weeklies

Utilizing weekly index options is one strategy that has the ability to shield traders from long-term volatility changes. For example, take a trader selling premium using an iron condor on an option index. If volatility begins to increase, the short duration of weeklys should help negate the volatility risk. Why? Options with one week or less until expiration have very small Vegas. That means low volatility exposure. Also, since expiration is so close, time decay on weekly options accelerates very quickly.

At-The-Money Volatility

Another strategy might be to create a position that gets long the volatility index. With volatility this low, a trader might consider buying exposure that benefits from an increase in volatility. Purchasing options at-the-money, that is months away from options expiration, provides high exposure to volatility. Relatively low or stable long-dated volatilities have little room for a volatility decline and lots of room for volatility to rise. They could be an interesting play to speculate on rising volatility, particularly if price works in the traders favor.

While the current environment is challenging, there are a variety of ways to trade options effectively. The primary key to options trading in this environment is to understand volatility and how it impacts options premiums. Many novice options traders discount the importance of volatility, and in many cases volatility is the reason why they struggle to produce positive consistent gains. An options trader that does not watch volatility is like a day trader that does not have access to real time quotes. If you currently do not understand volatility and how it impacts option prices, you should quit trading options and hit the books. Until next time, Happy Trading!

Dan Passarelli is the author of the book Trading Option Greeks and founder and CEO of Market Taker Mentoring LLC. Passarelli began his trading career trading on the floors of the Chicago Board Options Exchange and the Chicago Board of Trade making markets in options. He regularly shares trading insights and educational tips in his options blog. Dan can be reached through his website http://MarketTaker.com and can also be followed on Twitter at twitter.com/Dan_Passarelli.

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