Option Investor
Educational Article

Can The Bulls Come Out And Play Yet\?

Printer friendly version

Can The Bulls Come Out And Play Yet?
By Lee Lowell

Last week was hard to watch. I sometimes wonder if I'm doing myself any good by sitting in front of the computer all day. While I was still a floor trader on the NYMEX, a good portion of my trades were true "day trades", where I was in and out of the positions by the end of the trading day whether they were wins or losses. As time went on and the bigger positions I held, it was not always possible to go home with a clean slate but I would try to be as delta and gamma neutral as possible. But most of the time I tried to come home with an empty portfolio. The hardest part about being an at-home trader is that you can't trade like a floor trader. You can't just get in and out with that kind of speed, and you're not privy to seeing every order that comes down the pipe from other brokerage houses. Plus, the commissions costs would eat you alive.

I know most of you are thinking that you've never been a floor trader so you can't make the comparison. Just suffice it to say that being an off-floor trader really makes you become a true position trader. You need to become familiar with strategies that will work out over time. You need to know which plays to make in up, down and sideways markets. Education is the key. So if that's the case, then why do I still sit in front of the computer all day? Because I love the game, man! Once a trader, always a trader. As long as you cover yourself and don't blow it all on one play, and make rational and thought-out decisions, you can remain in the trading world for however long it takes.

Anyways...back to my original statement. Last week was hard to watch, but I'm getting that feeling that we may be very close to turning the corner. Everything's just getting hammered. I'm so glad that I finally was able to control my urge to keep buying more on every dip. Now I'm waiting for the upturn to begin in earnest before I use all my available cash. Patience really helps in this case. But as long as we're still not sure which way the next move is, let's make sure we know how to handle the present environment.

Have you been watching volatility? Not only has the VIX hit its highest point since March/April, but the implied volatility of many individual stocks have skyrocketed also. As noted many times in various OI articles, whenever the fear is rampant on Wall Street, volatility soars. And it usually happens when we have downmoves. This is because the downmoves are always fast and furious and the rationale of many traders gets thrown out the window. Active put buying is the catalyst that usually drives up the VIX and other stock's individual volatilities. As a sentiment indicator, the put/call ratio can also give us clues to when the market might turn around. Used in a contrarian fashion, when the put/call ratio reaches extremes and everyone is loaded up with puts, this is when we see a turnaround shortly thereafter.

So let's talk about how to use this high-volatility environment. As we know, this is not the time to be buying individual options unless the volatility on that stock is at low levels. At this point, I'm beginning to look at more bullish strategies with a conservative edge. This means selling covered calls that are slightly in-the-money. Not only does selling ITM calls give me a little more downside protection, but the higher volatility allows me to get more bang for my buck. On a certain stock, I could sell a covered call for 4 points, but 3 weeks ago when volatility was much lower, that same call was only trading for about 2.5 points, even with more time left! (all else being equal). If you're feeling slightly more bullish, then you can still sell ATM or OTM calls. They won't give you as much downside protection but your upside potential is higher.

On the flipside, we can sell puts or put credit spreads. Selling naked puts is a risky strategy of course, but as long as you know the consequences, then it could be a good play. Not only will the higher volatility allow you to sell further OTM puts than usual, but if you're aiming to get assigned the shares, your cost basis will be even lower. For example, 2 weeks ago on a random stock, you could've sold a put that was 20 points OTM for $5, but now with the increased volatility, that same put is worth $8 (all else being equal). To see the effects of increased volatility of your options, plug the numbers into your options calculator. Just bump up the volatility estimate and leave all the other inputs the same. You'll see how the premiums will increase. If you're not willing to take the unlimited risk that naked puts offer, then go with selling put spreads. Your risk is limited so you know what the potential loss could be. Once again, the higher volatility allows you to sell further OTM put spreads which increases the chance of them expiring worthless.

High volatility doesn't necessarily mean that buying options are off limits. Just don't buy individual options unless you're extremely psychic and you know for sure which way the stock is going to move. Buy call spreads or put spreads. The high volatility of one strike will be offset by the high volatility of the other strike. Check the skew too. You may be able to get the short side of the spread off at a more favorable volatility level. This is why I suggest getting a data feed vendor that can give you the option's "bid implied volatility" and its "ask implied volatility." This way you are sure to know exactly what volatility level you are buying and what level of volatility you are selling. It's not enough to just look at the "implied volatility" column within the option chain because that IV column is based on the last trade of the option. Well, that option could've traded days ago, so you're not getting up- to-date information. Just like when you want to buy the stock outright, it never makes sense to look at the last trade because it's already old hat. You need to see the stock's actual bid/ask to know what level you really can do the trade for.

Don't forget to look into you bag of other strategies to use in these situations. Backspreads are a great strategy to use when bullish and there is a reverse skew - meaning the lower strikes have higher implied volatilities than the higher strikes. Also, calendar spreads are a great way to take advantage of skewing between different expiration months. When volatility explodes, it's usually the front-month options that see the majority of it, leaving the further-out expiration months with less of a rise in volatility. This lets you sell front month options that will decay quickly while being long slower-decaying further-out options. It just takes a little education and trial and error to see how all these strategies play out. Give 'em a try.

Good luck.

Options 101 Archives