Option Strategies for All VIX Levels

10/29/2013 6:00 am EST

Focus: OPTIONS

Dan Keegan

Founder, Optionthinker.com

Option mentor Dan Keegan discusses different strategies that he uses depending on whether the VIX is at low or high levels

SPEAKER:  My guest today is Dan Keegan and we are talking about the VIX and how you trade around it when it goes up and down.  Dan, the VIX has been low for a long time.  What are your strategies here in terms of using options?

DAN KEEGAN:  When the VIX is at a continuously low level that means by definition the time though that is in the option premium is low, so at this low level it only has one way to go, so one thing you could do is you could buy an out of the money put by two out of the money puts and sell one also out of the money, but closer to being in the money, so you could actually do that for a slight credit.  You would want to do it two or three months out so that if there is a pop in applied volatility, you will reap the benefits of it. 

SPEAKER:  Is this a ratio trade?

DAN KEEGAN:  It is a ratio trade.  You are trying to do a Delta neutral, particularly you could buy two further out of the money, sell one near to being in the money put and if the market sells off a little bit and the implied volatility pops up, you can take the spread off for a nice profit. 

SPEAKER:  When you say Delta neutral, what do you mean by that?

DAN KEEGAN:  Delta is basically each option has a delta in it and one of the explanations for it is a Delta is what percentage chance that option will have of finishing in the money at expiration.  The more it is in the money, the higher that percentage chance will be. 

SPEAKER:  If the VIX has been historically very low here through the rest of maybe 2013 and into 2014, what are your thoughts and where do you think it is headed here?

DAN KEEGAN:  I think at some point it has to pop.  I know in 2005 and 2006 it was just flat for almost two years and people were saying well financial engineers have found a way to take volatility out of the market place and then 2008 and 2009 happened, so at some point it is going to happen.  When it does have a pop, then you can flip flop your strategies where you could do a call ratio spread where you are going to be net short calls.  Let’s say if the spider went down to 167 or something and you think it is going to stop there, you could maybe buy 170 calls and sell 173 calls, once again Delta neutral so you are not taking a pin in on which direction it is going to go, but if it does you are taking advantage of the changes in applied volatility.

SPEAKER:  How sophisticated an investor and trader do I have to be to try ratio trades?  I mean is this an intermediate level if you will type of option trade?

DAN KEEGAN:  Yeah, I would say so.  You kind of have to first understand how the GRATs work and how the option SPIA works, which is not really difficult, you just have to learn it.

SPEAKER:  When you are doing these ratio trades, we are talking about the VIX, the overall VIX, are we doing this on S&P options or could you even do specific stock options?

DAN KEEGAN:  Oh sure you could do it because the S&P and the VIX, they derive their value from the 500 stock, so I would say about 95% of the stocks would apply to it, stocks that on the way up their implied volatility drops and on the way down it increases. 

SPEAKER:  In terms of the number of contracts I should be doing with this, what is your recommendation?

DAN KEEGAN:  Well let’s say you could do maybe like 10 by or 20 by 10 on the put ratio and maybe 20 by 30 or 10 by 15 on call ratio spread.

SPEAKER:  Obviously, if you have the account size to do be able to afford that.

DAN KEEGAN:  If you have the account size, the thing is that they are not really that money intensive to do those spreads.

SPEAKER:  As long as it moves, you are not so much concerned about the direction as long as it does move in one of them. 

DAN KEEGAN:  Right, exactly.  In other words the put ratio spread, if the market keeps going up, it is kind of you can pocket your little credit and no harm, no foul, then if it goes down, then you get the increase in applied volatility and since your lawnmower options are now short, you profit that way.  The call ratio spread, you are kind of hoping that it stops moving and then the volatility comes up and you make money that way.

SPEAKER:  Dan, thanks for your time.

DAN KEEGAN:  Thank you.

SPEAKER:   You are watching the Money Show.com Video Network.

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