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Educational Article

Avoiding the Volatility Trap

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by Mark Phillips

Every time the VIX gets into extreme territory like we saw yesterday, I get waves of email asking if now is the time to buy calls in expectation of a strong rebound. In almost equal numbers, the questions fly in about whether to buy puts in anticipation that this time the bottom will fall out of the market. Without sounding like I wise guy, let me humbly submit that both of these questions are going in the wrong direction. While price action trumps all other metrics that determine option pricing, we can't afford to ignore the effect elevated volatility has on the price of an option we are considering for purchase.

Option sellers fully understand this conundrum and patiently wait for days when volatility moves to extremes. I personally know traders that only sell options when volatility gets to an extreme. Personally, selling naked options (whether calls or puts) has never fit my risk profile. Recall that as a buyer of an option, you have limited downside (the premium paid), while upside is theoretically unlimited. Sure there is a practical limit, as stocks can only go so high, or else go to zero. But there are numerous examples where an option can deliver 200%, 400% or even greater profit, sometimes in the span of a few days.

Put this relationship into the world of the option seller, and you can see that reward is limited (the premium received), while risk is theoretically unlimited. Sell a SEP $70 Put on IBM at the high of the day today and you could have taken in $2.00. That is the maximum return. If IBM falls through the July lows near $65 by September expiration, the option seller is looking at a $5 loss, or more. All of this can be mitigated through prudent use of stop losses, but that doesn't protect us in the event of a large gap down move.

But I'm getting off topic here, as I want to talk about how to trade directionally in a volatile market environment, without getting burned by overpaying for options due to sky-high volatility. Let's say your bias is bullish on a particular stock and you are considering the purchase of calls. If you are right, as the price of the stock rises, the volatility will likely be falling. This means that you are making money from the increase in the price of the underlying equity, but losing money as the volatility component of the option premium drops out of nose-bleed territory. So the stock has to move far enough (and fast enough) to overcome the premium drain of collapsing volatility. In fact, if volatility declines while the stock gradually moves higher, you can end up losing money due to the collapse of the volatility component of the option premium.

Directional put purchasers can get into trouble too. Let's say you think the stock is going to drop further and you purchase puts. If you're right, then all is golden. But if the stock reverses on you, your position loses value twice as fast. Price action is going against you and declining volatility causes the premium to decay even faster. Has that ever happened to you? Or am I the only one?

Obviously the recent market volatility has provided ample opportunity to make money on directional option purchases, if only we can pick the right direction. But the penalty for being wrong in a high-volatility environment is more severe than normal and can be a painful experience for the risk-averse trader. That's what makes the appeal of spread trading so strong in this sort of market.

For the uninitiated, a spread involves buying a call (or put) and simultaneously selling a call (or put) on the same underlying stock, but at a different strike price. There is a seemingly endless variety of spread strategies, both bullish and bearish, simple and complex. You've probably heard mention of bull call spreads, bear put spreads, ratio spreads, back spreads, butterfly spreads, and many others. Each has their own particular benefits and drawbacks, but the one thing they all have in common is that they allow you to insulate yourself from the effect of volatility.

You'll end up buying high volatility for the long portion of the spread, but at the same time you are selling high volatility with the short leg of the spread. The net result is that your spread position makes money if the price of the underlying moves in your direction and lose money if the underlying moves against you. But changes in volatility will not materially affect the outcome of the trade.

Let's look at a simple example of a Bull Call Spread and see how it works. Coming back to IBM, let's assume that we're bullish on the stock and are looking for it to rise back above the $80 level by September expiration. One way to play it would be to buy the $75 call (IBM-IO) for $1.95 and sell the $80 call (IBM-IP) for $0.45. The net cost of the trade is $1.50, and the maximum profit (difference between the strikes - net cost) is $3.50. That's better than a 2:1 reward to risk ratio, so that would fit my risk profile. I'm not recommending this as a trade, just pointing out that it is a way to put on a bullish directional trade, without subjecting ourselves to volatility risk. No matter which way volatility moves over the next two weeks, price action will be the dominant determinant (nice alliteration, eh?) of our profitability in the trade.

We could similarly put on a Bear Put spread on the expectation that the price of IBM will fall over the next 2 weeks. Buying the $70 put (IBM-UN) for $1.35 and selling the $65 put (IBM-UM) for $0.55 would cost a total of $0.80. Maximum reward would be $4.20, giving us a nice reward to risk ratio as well. The key point is that price action becomes our primary focus, rather than stewing over a loss of volatility premium.

With only 2 weeks until expiration, we might also choose to limit our exposure to time decay in the trade by buying an ITM option and selling an OTM option. Applying this wrinkle to the Bear Put spread would have us buying the $75 Put (IBM-UO) for $3.30 and selling the $70 Put (IBM-UN) for $1.35. Net cost has risen to $1.95, but even on a slight decline in price, the position works in our favor. The OTM option will expire worthless if IBM remains above $70, while our long Put (IBM-UO) will retain intrinsic value so long as it remains ITM.

We've talked about risk and reward in these trades, but the other important issue when trading spreads is where is the breakeven point on the trade. For the Bull Call spread, the trade will be profitable, so long as IBM is above $76.50 at expiration (the level of the long call plus the cost of initiating the trade). For the first version of the Bear Put spread, the trade is profitable so long as IBM closes below $69.20 ($70 - $0.80). And for the OTM/ITM Bear Put spread, the trade is profitable at expiration, so long as IBM remains below $73.05.

Spreads can be held until expiration or closed out early, depending on price action and your risk profile. Like I said above, my intention with this article is not to advocate putting on a specific spread trade. Rather, I wanted to highlight the advantage of utilizing this strategy in a high-volatility environment. It can allow us to place a directional trade, without assuming the volatility risk inherent in a long put or long call position.

I know this has been a rather brief introduction to the concept of spread trading. If you're an old hand at this type of trading, then hopefully this serves as a reminder that this is the sort of market in which this strategy shines. If this is a new concept, then hopefully I've given you something new to chew on. If you'd like more details about specific types of spreads, let me engage in a bit of shameless self-promotion and point you towards some of my past articles in the Trader's Corner archives. Last year, I wrote a series of articles on different types of trades (far from all-inclusive), where I talked about basic spreads, back-spreads, ratio back-spreads and butterfly spreads. If any of that sounds intriguing, then follow the links below.

More Details on Spread Strategies
To Spread or Backspread...That Is The Question
Call Ratio Backspreads - The Final Chapter
More Corrections and a Kickoff for Butterfly Spreads
The Long Butterfly Spread - Picking the Right Candidate
Spreads - The Final Installment (The Short Butterfly)

I should also point out that we have a prime resource at our disposal for elucidating some of the finer points of using spreads. Our editor, Steve Price, in his prior life at the CBOE paid a lot of attention to spread pricing and volatility. I'm willing to bet, he's got a few nuggets of wisdom on the topic to share with all of us. I'm more than happy to answer any and all questions on the topic of spreads (within my limited knowledge base), but if you've got an interesting question or suggestion for a future article, we just might be able to twist Steve's arm and learn even more. Thanks in advance, Steve! GRIN

Have a great week!

Mark

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