When faced with high volatility, many options traders turn to these five strategies designed to capitalize on elevated volatility levels.
Trading options is about more than just being bullish or bearish or market neutral. There’s volatility. Limitations on capital. Stronger or weaker directional biases. Whatever the scenario, you have the choice of a logical options strategy that can be risk-defined, capital efficient, and/or have a higher probability of profit than simply buying or shorting stock. Of course given the risks, which are frequently greater and more complex, options are not for everyone.
By sorting each strategy into buckets covering each potential combination of these three variables, you can create a handy reference guide. You could even print it out and tape it to your wall. Doing so might help you run through the process of making speedy trading decisions should you need to or if warranted.
We’ll help you get started with this list of option strategies designed for a high-volatility market environment. Notice how most of them are composed of the basic vertical and calendar spreads. As you review them, keep in mind that there are no guarantees with these strategies. A volatility (vol) spike is a reflection of heightened uncertainty and typically price fluctuations.
Typically, high vol means higher options prices, which you can try to take advantage of with short premium strategies. High vol lets you find options strikes that are further out of the money (OTM), which may offer high probabilities of expiring worthless and potentially higher returns on capital. Pushing short options further OTM also means that strategies have more room for the stock price to move against them before they begin to lose money. Here are a few bullish, bearish, and neutral strategies designed for high-volatility scenarios.
STRUCTURE: Sell put.
CAPITAL REQUIREMENT: Higher.
RISK: Technically risk is defined, as a stock can go all the way to zero, but no lower. But even though risk is defined, zero can be a long way down. See figure 1.
Those with an interest in this strategy could consider looking for OTM options that have a high probability of expiring worthless and high return on capital. Capital requirements are higher for high-priced stocks and lower for low-priced stocks. Your account size may determine whether you can do the trade or not. In fact, some accounts require enough capital in the account to purchase the stock if the seller is assigned. This is known as a “cash-secured” put.
Many traders may look for expiration in the short premium “sweet spot,” which is typically between 20 and 50 days out, depending on the level of implied volatility, upcoming news, and company announcements, among other factors. Targeting the sweet spot aims to balance growing positive time decay with the high extrinsic value. Choose a stock you’re comfortable owning if the stock drops and the short put is assigned. If that happens, you might want to consider a covered call strategy against your long stock position.
STRUCTURE: Sell put, buy lower-strike put of the same expiration.
CAPITAL REQUIREMENT: Lower; depends on the difference between strikes.
RISK: Defined. See figure 2.
Traders consider using this strategy when the capital requirement of the short put is too high for their account or if defined risk is preferred. Traders might target credit for a short vertical around 1/3 of the width of the strikes (e.g., $0.33 if the strikes are $1 apart). Traders commonly consider looking for expiration in the short premium “sweet spot,” again, typically around 20 to 50 days out. Some traders create a short OTM put vertical by looking for an OTM put that has a high probability (perhaps 65% to 70%) of expiring worthless, then looking at buying a further OTM put to try to get the target credit, typically one or two more strikes OTM.
STRUCTURE: Sell call, buy higher-strike call of the same expiration.
CAPITAL REQUIREMENT: Lower, but depends on the difference between strikes.
RISK: Defined. See figure 3.
Some traders look to target the credit of the trade at 30% of the difference between strikes (e.g., $0.30 if the strikes are $1 apart). Consider looking for expiration in the “sweet spot,” typically between 20 to 50 days out. Look for an OTM call that has a high probability of expiring worthless (again, perhaps 65% to 70%), then look at buying a further OTM call to try to get the target credit, typically one or two strikes further OTM.
STRUCTURE: Sell lower-strike put vertical, sell higher-strike call vertical; the distance between the long and short strikes is the same.
CAPITAL REQUIREMENT: Lower; depends on difference between strikes.
RISK: Defined. See figure 4.
Consider targeting the credit to a fixed percentage of the trade, such as 40% of the difference between the long and short strikes (e.g., $0.80 or higher in a $2-wide iron condor). Traders generally look for expiration in what some consider to be the the short premium “sweet spot,” typically between 20 and 50 days out, to balance growing positive time decay with the high extrinsic value. Higher vol lets you find further OTM calls and puts that have a high probability of expiring worthless but with high premium. Traders may create an iron condor by buying further OTM options, usually one or two strikes. You might not want to put this position on for a small credit no matter how high the probability, as transaction costs on four legs can eat into the profit potential.
STRUCTURE: Buy one lower-strike option, sell two higher-strike options, buy one higher-strike option; all calls or puts, all strikes equidistant.
CAPITAL REQUIREMENT: Lower.
RISK: Defined. See figure 5.
Max profit is achieved if the stock is at the short middle strike at expiration. Traders may place the short middle strike slightly OTM to get a slight directional bias. The probability of profit is usually under 50% due to the narrow profit range of a long butterfly. High volatility keeps value the of ATM butterflies lower. Butterflies expand in value most rapidly as expiration approaches, so traders may look at options that expire in 14 to 21 days. Short gamma increases dramatically at expiration (i.e., increases the magnitude of the change in value) if the stock is at the short strike. Consider taking profits—if available—ahead of expiration to avoid the butterfly turning into a loser from a last-minute price swing.
NOTE: Butterflies have low risk but high reward. They’re often inexpensive to initiate. Some traders would say they’re inexpensive for a reason, which is that maximizing the return from a butterfly requires not only a pinpoint target in the stock price but also pinpoint timing.
Let’s face it: Periods of high volatility can be unsettling. After all, volatility is related to uncertainty, and, where money is concerned, uncertainty can be unpleasant. But if volatility has you feeling like you’ve been handed a bag of lemons, experienced option traders can consider these strategies as a way to try and make some lemonade.
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