Every successful business must have an edge, a consistent source of profitability. A casino’s edge is the rules of the game, which give them a mathematical advantage. A seller of goods has a way to obtain the goods, and a way to market and sell them at higher prices. In option trading we have some of the aspects of both of these types of businesses if we do it right.
We’ve been talking about the Greeks for a few weeks now. These measure the effects of the three things that can change option prices: underlying asset price movement; passage of time; and changing volatility. Our edge as traders comes from the ability to forecast accurately at least one of these three variables, together with the knowledge about which types of strategy naturally take advantage of the change that we forecast. Different option strategies include different combinations of long calls, short calls, long puts, short puts, and long or short underlying assets. Each of these strategic combinations has a predictable degree of response to each type of change.
If we are very confident that the price of a stock will rise, or that it will fall, we can choose from several strategies that profit in the event we’re right about the direction. These are called, naturally enough, directional strategies. Some directional strategies also benefit from rising volatility; others from falling volatility; and still others are neutral as to volatility.
If we believe that the underlying price will be range-bound for a while, we can select a strategy that wins if we’re right about that.
If in addition to our directional opinion (called our directional bias or just, bias), we have an opinion about volatility too, we’ll select strategies that benefit if we’re right about that. Some range-bound strategies like increasing volatility, others hate it.
If we have no opinion at all about what the underlying price will do, but we believe that we know whether volatility is more likely to rise or to fall, we can choose from multiple strategies that benefit from that.
And if we don’t have a clue about either price or volatility, we could choose a strategy that just counts on the passage of time. But betting that time will pass is a pretty safe bet. The more certain any bet is, the less we get paid for making it. In fact, option prices are constructed so that if we did choose a strategy to completely eliminate all risk from price or volatility, we would, on average, get paid the same as if we lent out our money at the minimum available interest rate (called the risk-free interest rate).
So for there to be any point in an option trade (instead of leaving our money in the bank earning interest), we do need to have an opinion about price, or about volatility, or both.
Here’s what a decision matrix for price and volatility might look like:
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
Above we have five possible opinions about price, and four possible opinions about volatility, for a total of twenty possible opinions altogether (including no opinion at all). If we do have no opinion about price and no opinion about volatility, there is no good option strategy. For each one of the other nineteen choices, there is at least one option strategy that will pay us well if we’re right. For the next few weeks, we’ll talk about a representative strategy for selected ones of these nineteen combinations of opinions.
But first, let’s think about how we would come by a credible opinion about price and volatility in the first place.
As far as the underlying price is concerned, that is the point of technical analysis, and a main focus of our trading classes. Technical analysis is chart reading. If we know what to look for on a chart, the previous price behavior shown there gives us solid information about what is most likely (although not certain) to happen next. I can’t fully teach those classes here in this column. Suffice it to say that our opinion about the direction of price comes from our technical analysis. Our discussions assume that we can read charts and form an opinion about price.
We also have ways to form an opinion about volatility. The type of volatility that I mean here is implied volatility (IV), the kind that is embedded in every option’s price. IV can be measured, calculated, and graphed over time for every individual underlying asset. For a particular underlying, we can compare the current level of IV to the historic range of IV levels. This enables us to see whether IV is currently higher than it usually is, lower, or about the same. In general, we expect IV to spend most of its time around its average value. If it is lower than that, we expect it to rise back toward its average. If it’s higher than average, we expect it to fall. The farther from the average IV currently is, the stronger our opinion will be. If IV is neither much higher nor much lower than average, it could go either way and we would have no opinion about it.
Just as there is a general environment for stock prices (indexes like the S&P 500 or the Dow Jones Industrial Average are rising or falling), there is a general environment for IV. If investors are very worried about a possible drop in prices, they will be eager to buy options to hedge their positions. They bid option prices up, even though there might not yet be any movement in the underlying. Higher option prices equals higher IV. On the other hand, if investors aren’t afraid of anything, they will be less interested in hedging. Option prices (and therefore IV) will be lower.
We can get a quick read on the general IV environment by looking at the IV of the S&P 500 index itself. The IV of the S&P 500 is called the VIX, for Volatility Index. When it’s low, then the IV of most individual stocks will be low too. When the VIX returns toward normal, so will that of most stocks. In that case, we can look for the individual stocks or ETFs that are at the most extreme low IV levels, and choose an option strategy that wins when IV rises. Same thing in reverse if the VIX is at a level that is extremely high. We expect it to drop, and to drag the IV of most stocks down with it. So we look for the stocks with the most extreme high IV and bet on their IV to drop.
That’s the general approach. Each week, we’ll talk about a particular price/IV opinion, and a strategy that will work well if our opinion is correct. Knowing what to do when is our edge.
For questions or comments about this article, contact me at rallen@tradingacademy.com.
