Josip Causic of Online Trading Academy outlines these different types of option trades, some of which are more appropriate based on the market trend and implied volatility.
This article will give six common-sense option trading strategies based on both implied volatility and the market’s trend direction. First, bullish scenarios will be looked at, and then bearish ones. Within each scenario there will be three subgroups—strongly bullish, moderately bullish, and slightly bullish.
The tables in all of the figures follow the same format. Starting on the left: Market Bias, Stock Action, Option Action, the trade Risk, Reward, and in Bold Letters the IV reading.
Option Trade 1:
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The scenario that matches Figure 1 includes the mindset of a trader who is very bullish on the underlying, yet at the same time wishes to have some protection for the duration of the trade.
The prerequisite actions prior to both purchases, stock and put options, is to verify whether the IV is low. It is then that the trader can proceed by simultaneously entering into this protected bullish position.
The fact that he purchased both the stock and the put means that there are no limits to his upside potential. If the stock goes up, the value of the put decreases, yet the trader already accepted the cost of the put as a way of insuring the long investment. Nevertheless, if the stock tanks a lot, then every penny paid for the put would be viewed as a smart investment. Figure 1 can be compared to owning a car with insurance on it.
Option Trade 2:
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In this second scenario, the trader is bullish on the stock, while the IV is in its mid range, meaning the options are neither overpriced nor underpriced. The trader chooses to go long on the stock, yet he or she does not want to pay from his or her own pocket the cost of a long put. He or she finances the put purchase by selling a call on the same expiry cycle.
Please read this article on Collars for an in-depth explanation of this strategy. In short, the position profit and loss remain within a range because of the two options—both risk and reward are limited.
Option Trade 3:
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Although this strategy is known to everyone as the covered call, what is not so well known is that it is the most dangerous scenario out of the three that we are discussing.
Let us go over the facts. The trader feels the underlying over the long term will be bullish and he or she does not mind holding it during minor pullbacks. Therefore, the out-of-the-money (OTM) calls are sold in proportion to his or her stock holding. Limited premium is received and there is anticipation that the underlying will not go over the OTM call.
Next: Option Trade 4
|pagebreak|But what if it does? Could there be a stop loss? Well, if the stop is placed on the underlying and it gets filled, the trader is left with a naked call. Also, there is no protection to the downside if the trader owns the stock. Take a look at the table in Figure 3 showing what the risk is.
Option Trade 4:
Moving on to the bearish scenarios; the figure below shows shorted stock and a call that is purchased.
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To a novice eye, at first this strategy might look as the most contradictory one. If a stock is shorted in isolation, the position would carry unlimited risk to the upside. However, due to the long call, that “ain’t so.” The short stock gives us negative delta and the long call gives us positive delta. The long call limits the risk to the upside.
Option Trade 5:
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Figure 5, above, is still a short position because the underlying is the engine of the trade. The short put finances the long call, which covers the short stock. So risk is limited to the upside by the long call, but reward is limited to the downside due to the short put.
Option Trade 6:
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In this last scenario, since there is overinflated premium due to high IV, an ATM put is sold. If the stock goes nowhere, the fluff (extrinsic value) of the ATM put goes out.
Keep in mind that if there is any intrinsic value, no matter how small, in that ATM put if it is held until expiry, the put will become long stock, which in turn would make the overall position flat. Short stock and long stock equal no position.
The risk is unlimited to the upside and the reward is limited. The key to this strategy is not just selling the put when the IV is high, but also put selection.
In conclusion, this article explained six common-sense actions that take into account both implied volatility and the market’s trend direction. The point is not to look at just the price chart, but also to take into consideration the IV. Trading options is all about the IV, leverage, and hedging.
Josip Causic is an option trading instructor with Online Trading Academy.
