Date: 3/25/2021
Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
Options and stocks are not the same.
Stock prices move up or down based on buying and selling. That’s pretty much it.
Unless you’re mainly trading in highly speculative OTCs, shares may go up or down but seldom go to zero.
And they certainly don’t just magically change in price for seemingly no reason!
Don’t get me wrong, stock trading takes lots of skill if you want to make money. However, with options, we must consider many variables that stock traders don’t deal with.
Expiration dates, time decay, early assignment, open interest, and continual fluctuations in volatility.
It’s this last one that I want to talk about today.
You hear it all the time.
“This market’s really volatile! Be careful!” or “That’s the most volatile stock I’ve ever seen!”
But what is volatility exactly, and how do we use it to our advantage?
I could bore you to death with a long-winded lecture on the options Greek called vega and its use in calculating theoretical value using the Black–Scholes formula.
Are you excited yet?
Don’t worry, I won’t. I want you to stay awake and learn something.
Volatility is EXPECTATION.
It’s the sense that a big move is about to happen, but no one knows in what direction.
A volatile stock is something like TSLA that’s prone to enormous price swings. It’s difficult to know just where it will be from one day to the next.
Compare that to a behemoth like AMZN.
Despite a few occasional bull runs and sell-offs, it pretty much chugs predictably along.
But volatility might also affect the broad market like it does every February and March. Hedge fund and other institutional rotations and rebalances.
A churning school of whales seemingly turning the major indexes into penny stocks.
There’s also a value on every equity called implied volatility or IV. When this rises, options become expensive, and when it drops, they’re cheap!
This is why you must pay attention to both market volatility as a whole and look at the IV of any underlying you trade.
If you buy during high IV, you’re overpaying; if you sell during low IV, you’ll cut yourself out of that juicy premium!
Buying low and sell high in action!
Except here, you can win or lose money even if the stock price doesn’t move at all.
Consider this example:
In the big sell-off this week, you bought a put on TSLA – the 150.75 strike for Mar 18th,2022.
That’s 359 days away – close enough to a year for easy calculation.
You would have paid $150.75 per contract for that or 15,075 dollars.
If the stock price sat at $630.27 just as it closed today, and the IV calmed down from its current 78.3% to 50%, your option could suddenly be worth 7.3% less.
That’s a drop of $1100.48!
I have a feeling lots of people are going to get smashed buying puts on this sell-off. March is usually hellish, but April tends to be kind to traders, historically speaking.
The one-two punch of a market rebound and volatility collapse is a bank breaker!
So how do you use volatility to your advantage?
In highly volatile markets, particularly on high IV stocks, use SELLING strategies!
Credit spreads, unbalanced butterflies, iron condors, and the like are golden.
Collect that rich premium! Let the volatility drive up the price for the buyer, not for you.
Guess what to do when the market or stock isn’t so volatile?
BE AN OPTIONS BUYER!
Long calls, long puts, debit spreads and similar trades win the day.
Of course, every trade needs the proper setup, risk/reward ratio, and management. It must also fit your skill and your plan, but ignore the IV, and you’ll be missing a significant piece of the puzzle.
If you want to improve your trading, pay close attention to the market condition and always check the stock’s IV before deciding on a trade!
We retail traders are little fish in a big ocean.
If we’re going to survive and thrive, we need EVERY little advantage we can get!
For more in-depth tips on how to gain your EDGE, be sure to check out my Hood Talk videos on Rogue Investing’s YouTube channel.
Next time we’ll discuss a bit more about just how important psychology is to our trading.
