What to Do When Single Options Trades Are Muddled
04/02/2010 12:01 am EST
We seem to be at a crossroads with options these days. On one hand, most options have an implied volatility near 52-week lows. In fact, many are trading at or near levels not seen in two years or more. Who would want to sell options when they are this cheap?
On the other hand, the only important aspect of an option's volatility is whether it is too high or too cheap relative to the volatility of the underlying instrument itself going forward.
We can't know future realized volatility, so the best we can do is look at the recent past and project it going forward. And on that basis, implied volatility looks high.
Even with the recent modest uptick in volatility, ten-day realized volatility in the S&P 500 (SPX) and SPDR S&P 500 ETF (SPY) is still about 8. That's less than half of the CBOE Volatility Index (VIX) right now.
So what do you do when options are too cheap to sell by one definition and too pricy to buy if you want to actually earn money from them? Spreads.
Let's say you like stock XYZ. You could buy at-the-money (ATM) calls; after all, they look cheap, and they're probably at low-end volatility. But, alas, XYZ itself is moving at a snail's pace.
So why not sell put spreads instead? The max gain on the calls is clearly better, and each has defined risk, but the calls trade at a premium and, thus, first need the stock to lift a certain amount for you to "win."
The put spreads (we'll presume they're roughly ATM) will do modestly better on a slow grind up and considerably better for the first part of a decline. That describes a low-volatility environment, so if you expect this sort of meandering action to continue, it could be a good way to sell some premium without making a risky bet.
Suppose instead of being bullish on XYZ, you simply don't expect a big move in the stock, but, again, you don't want to make a head-on volatility sale. How about taking that put spread we just discussed and selling an out-of-the-money (OTM) call spread against it? This is known as an iron condor.
Intuitively, a low-volatility environment does not feel like a great time to employ this strategy. But in a way, it's the best time put on an iron condor—at least on a relative basis versus outright option premiums sales. It allows you to bet on a stock remaining range-bound without taking an open-ended bet against volatility.
Your max gain is the total premium you take in combined on the put spread sale and the call spread sale. Your risk is that one side maxes out and you lose the intrinsic value of the maxed-out spread less the total premium you took in.
What I'm trying to say here is that an objectively low, but actually overpriced volatility backdrop is not a bad time to employ defined-risk volatility sale strategies.
By Adam Warner of DailyOptionsReport.com