Today’s Trading Lesson From TradingMarkets

PS To learn professional options strategies, try the

TradingMarkets Options College.

Point And Counterpoint: Volatility Vs. Price

By Len Yates

In stocks, volatility increases as stock prices
decline, and volatility declines as stock prices increase. 

The reason
volatility increases as stocks decline is presumably because falling stock
prices mean deteriorating business conditions, and deteriorating business
conditions mean higher risk from worsened visibility. This leads to greater
daily price fluctuations (on a percentage basis) and thus, greater volatility. 

On the other hand,
as stock prices climb, this implies improving business conditions and greater
stability. Thus, stocks exhibit smaller daily price fluctuations, i.e., lower
volatility.

Would logic dictate
that the converse be true? Does a period of low volatility presage a drop in
stock prices? While logic would not dictate this (it is false logic to assume
the converse is true), it turns out from historical observation that this is
often the case. Does extremely high volatility mark the bottom of a bear
market?  Again, very often it does.

In the illustration
below, the solid red line represents statistical volatility (how much the price
of the QQQ has bounced around recently).  The dashed blue line represents
implied volatility (how much underlying volatility is implied by current option
price levels). Notice how often volatility peaks went with market bottoms, and
volatility lows corresponded with market tops.

So what does this
mean to the options trader?  How can we profit from this information?

For one thing,
volatility helps as a confirming indicator. When volatility is high, for
example, you know that the bottom is near. When volatility is low, one must be
on guard for a potential breakdown. Another thing is that this should make us
want to buy options at market tops and sell options at market bottoms.

When volatility is
low, we can watch for signs of a breakdown and go short by buying puts. One of
the most reliable signals of a breakdown is when the market begins to fall off
the right shoulder of a head-and-shoulders formation. The best strategy to use
would probably be to buy puts, as options are cheap when volatility is low.  If
a selloff ensues, the options expand from the double effect of falling prices
and (very likely) increasing volatility.

To get more of a
bang from a possible volatility increase, one could buy farther-out options, as
farther-out options expand more when volatility increases. Of course, buying
farther-out options costs more money, and they will respond more slowly to
falling prices.  However, as a lower-risk position, especially when compared
with the “fast lane” nearby options, this may be appropriate. It is important
for the trader to take appropriate risks according to his own goals and
temperament.

Once prices begin to
fall, and the options become expensive, if one still wanted to buy puts to play
for further downside, he could switch to buying deep in-the-money nearbys to
avoid paying extra for the newly inflated time premiums.

When volatility is
high, and prices are showing signs of bottoming (i.e., the chart is showing a
double-bottom formation), this would suggest going long by selling naked puts,
as options are expensive when volatility is high. If a rally materializes, the
options die from both rising prices and falling volatility.

However, selling
naked puts in the face of a down-trending market that you believe is about to
reverse to the upside, is rather like standing on the tracks in front of an
oncoming train and shouting, “Halt!”  It might work, but it’s kind of scary. To
reduce the stress to acceptable levels, one can simply use a small position, but
then you don’t make much money when you’re right. Another approach is to use a
credit spread. While a credit spread would not respond to declining volatility
nearly as well, it does limit your risk. And finally, there is covered writing
and covered combos (a covered write plus naked puts), both excellent strategies
that put the odds in your favor by selling expensive options.

In practice, I have
found the buying of puts at the start of a breakdown is far more rewarding than
the selling of options (naked or covered) at a suspected bottom. Long puts
expand dramatically during a market selloff. At a suspected bottom, sometimes I
feel more comfortable just buying a few of my favorite stocks. If I feel
strongly about my timing, I might even load up with extra shares “on margin” for
a short time. Despite what they say about the risks of buying stock on margin,
it can be less risky to do that than some of the options strategies you might
employ at that juncture.