“Non-Directional” Options Trading
10/27/2011 1:00 pm EST
Options educator Steve Lentz discusses market-neutral, or Delta-neutral option strategies, which are designed to make money regardless of market direction.
Options traders have a lot of different strategies at their disposal, if they can use them. So which ones are the best to use right now?
Our guest today is Steve Lentz from OptionVue. Steve, you talk about something at the Traders Expo that is called “non-directional” strategies. What do you mean by that?
That’s right. In the world of options trading, you can employ certain strategies where you can make money whether the market goes up or goes down; we do it through the selling of options.
It is called selling options in a market-neutral or a Delta-neutral way. So what we like to do is target markets that have options that we consider to be chronically overvalued.
Now what do we mean by “chronically” overvalued? We mean that the options have time premium that is implying a volatility level higher than typically what actually comes to pass; that is where the typical implied volatility is higher than what the historical volatility is of the underlying index.
See related: Learn to Spot Option Bargains
We do a lot of index work. Once you target markets that are chronically overvalued, you now have a volatility edge and you can employ strategies like butterflies, condors, or calendars in a market-neutral way so that no matter which way the market goes, you can still make money.
Can you give me an example of one of these markets that is chronically overvalued?
Well the equity indexes are prime for this kind of thing. There’s a lot of expectation on the downside—some would call it fear, we would just call it expectation for movement—but those puts get to be quite heavily priced, priced higher in terms of volatility and their implied volatility priced higher than what the underlying index typically experiences in terms of volatility.
So if I am going to sell puts that are overvalued, how do I then protect myself, because you hear that naked put selling is very dangerous?
Oh absolutely. We are talking about non-directional selling, just selling puts or even doing credit spreads in the puts; that is a bullish strategy.
We are talking about butterflies, where you are selling at-the-money premium, both calls and puts at the money and then buying the wings way out there. That is called an iron butterfly, where you are selling an at-the-money call, at-the-money put; buying an out-of-the-money call, buying an out-of-the-money put.
Two rather large credit spreads for those that are already familiar; those at-the-money options will deplete in time premium much quicker than the ones out on the wings that don’t cost very much. That is how you make money.
What kind of sophistication do I need to have as a trader? Do I need to be pretty experienced in options to put on something like this?
You would have to have a degree of education, some experience, particularly the tools to be able to analyze those kinds of positions.
When you go long stock or short stock, you intuitively know if long stock, you make money if the market goes up. When you start piecing together option trades, particularly two or more legs, things can get kind of complex and you are going to have to get some tools to help you do the math so that ideally, you can see from a graphical standpoint how much money you could make or lose if the market does this or that.
One last question on those overvalued indexes. Are there certain times of the year or before options expiration week that this is best used?
That’s a great question. You know, not seasonally like that; more related to the bullishness or bearishness of the market.
Typically, when the market is going up, these equity indexes will have volatility levels that are lower than in a market environment where they are going down. When markets are going down, their volatility levels get to be more elevated and it gets more difficult to trade from a non-directional standpoint in a bearish or neutral market.
If it is bullish to bullish-neutral, that is the environment you want to have. When it is rolling over, the volatility is getting kind of high, you have to watch out a bit.
So we really look for markets where we call it statistical volatility or historical volatility; when that is trending downward, typically in more of a bullish-type market.