In volatile markets, buying put options is an excellent form of downside protection, says Dan Passarelli, while option straddles can be profitable regardless of market direction.
We’re here with Dan Passarelli, who’s going to talk to us about strategies for using options in a volatile market. So Dan, how do we use options to take advantage of the volatility and to protect us from the volatility?
The most natural way to use options in regard to volatility is as protection. Even conservative investors who own stock and are afraid of market volatility to the downside want to be able to protect against further declines in the market.
So what traders can do is buy a put. Maybe you own a stock at $50 a share and you want to make sure that if the stock falls below, say, $45 a share—10%—that that you don’t have any further losses.
Well, you can buy a veritable insurance policy. You can buy the 45-strike puts, which allow you to sell the stock at $45 a share no matter what happens.
That sounds like a great idea because it sort of leverages the stop loss that somebody might put on their stock if they were, say, a trader.
Yes, in fact, in my opinion, buying a put is much better than a stop loss, because when you buy a stock as an investor, you tend to hold it for awhile, and you have what’s known as overnight risk.
Every once in awhile, something happens overnight after the market is closed and before it opens again, and sometimes that can lead to a very, very big drop in the stock market. We’ve seen that over the last couple years.
Now, a stop loss doesn’t work under those scenarios. There’s no trading overnight, so if the market opens 20% lower, that’s where you’re getting filled, even if your stop loss was 2% lower.
This scenario doesn’t play out all the time; it’s pretty rare, but when it does, it can be disastrous. So using a put protects you because you hold the put overnight along with the stock.
Interesting. The way the global markets are today, by the time the US opens, there are reports out of Europe and Asia, and everything is starting to trade in more of an international context, which means that it’s trading 24 hours a day.
So, the options tend to be a little bit more advantageous than simply setting stop losses for that reason. Are there any other strategies that investors could use?
Sure. The opposite strategy is not a defensive play, but an offensive play: being able to capitalize on volatility, and the classic example of that is the straddle.
That’s when a trader buys a call and a put at the same time on the same stock with the same strike price.
So you think of a put, and it enables me to profit when the market falls, and a call enables you to profit when the market rises. But, because they both have limited risk, if you make money on the call, you only lose a little bit on the put.
And, if you make money on the put because of a big drop, you only lose a little bit on the call, so you end up with profitability whether the market goes down or up.
You can make money either way, so if the market experiences volatility, you can be a winner.