In my last article, First Find The Opportunity, Then You can Apply the Strategy, I mentioned how we really don’t look for “option trades” as much as we look for opportunities in the actual stock; opportunities that can then be better exploited by the use of options, as opposed to actually trading the stock. So then, the question you still may be asking yourself is, “Where do the options fit in?”
Well, to answer that question, let’s start at the beginning, and proceed in a step by step progression to see “where” and “how” options fit in.
After finding and identifying an opportunity in a stock, you need to hypothesize on what the future movement in the stock might be. Will this be a fast moving opportunity, like a break out or a break down? Will it be more of a longer term trending movement? Will it create an increasing or decreasing implied volatility event?
Once you have figured out what you believe the stock is most likely going to do, how fast it’s going to happen and what implied volatility is likely to do, you can now isolate which option strategy will work…and which ones will not.
Once you figure out which strategies will work (and there is always more than one that will), it is time to go into the options market and see how the options are priced in terms of implied volatility level. Depending on the implied volatility level of the options that you are going to use, it will become clear what you need to do.
One strategy will become optimal, based on the volatility level the options are trading at. Most of the time, your default or preferred strategy will be the optimal one.
Sometimes, your default strategy will work and become the optimal strategy. This may happen if you change the construction of the strategy, due to an unusual volatility level either much higher or lower than the average.
On some occasions, an extreme volatility level can force you from one strategy to another in order to find the optimal strategy for that particular and specific opportunity.
For instance, let’s say that you believe that AAPL is due for a run to the upside over the next few months. You know that normally the Stock Replacement Strategy teamed with the rolling technique is the best (most optimal) strategy to use for this type of situation.
The vertical spread would also work, but it would not be optimal in most situations as the vertical spread has a limited potential profit scenario defined by the “cap” of the short option.
The decision as to which strategy to use for this opportunity in AAPL largely rests with the level of implied volatility.
So, we now go into the options market and we take a look at the level of implied volatility. If we find it to be a little low to a little high (around the average), then we can simply use our Stock Replacement Strategy by purchasing the appropriate delta call (more on that in future articles) in the appropriate month (again, more on that in future articles) to optimize our strategy to this specific opportunity.
However, if volatility is abnormally high, then the cost of our Stock Replacement Call could become prohibitive. The reason for this is two-fold. First, the increase in volatility will increase the amount of extrinsic value in the option, thereby increasing the option’s total cost.
This will be compounded by the fact that the increased volatility will also have an effect on the deltas of the options; this is known as trumpification.
The rising volatility will cause a decrease in the delta of the in-the-money options (ITM), which could force you to go deeper in-the-money to find the optimal delta you need.
By going further in-the-money in the case of a call option, you will be going to a lower strike price which would mean that you would be going to an option with much more intrinsic value and thus a considerably higher price. This could cause a prohibitive price increase and eliminate you from using the Stock Replacement Strategy!
But, this does not necessarily eliminate you from taking advantage of the opportunity. It just means that due to the unusually high level of implied volatility, the Stock Replacement Strategy is NOT going to be the optimal strategy. In this specific situation, at this unique time, a different strategy…that is not normally optimal…may become optimal.
In this case, a vertical spread may wind up being the more optimal strategy, e.g., trading stock direction under extremely high volatility situations. So, now the vertical spread comes to the forefront. Obviously, if the unusual, extremely high volatility situation was the reason for the move from the normally better Stock Replacement Strategy (typically the default strategy for trading directional stock movements), then the optimal construction of our vertical spread becomes readily apparent.
You must construct a vertical spread that benefits the future resulting decrease in volatility. You must construct it as a short Vega vertical spread.
We know that volatility almost certainly will have to come back down (as volatility is mean-reversive) and even if it doesn’t, the added extrinsic value that the volatility increase put into the option, will definitely have to come out fully at option expiration.
This is how your trading ideas should develop. Start with using the stock to find opportunities, and then move into the options market to tell you which option strategy will be the most optimal and the best (most optimal ) way to take advantage of it!
See you all next time!
Ron Ianieri is owner of Ion Options a company he started in 2010. He is also lead instructor at Options Monster Education and editor of the highly successful newsletter “The Income Strategist”. Ron has been trading options for more than 27 years and is also the author of the book “Options Theory and Trading” published by John Wiley and Sons. Currently Ron travels the world teaching investors the same successful Options class he developed during his years on the trading floor.