High Volatility Trading

By: Todd Horwitz

The following is an excerpt from Todd "Bubba" Horwitz’s Bubba’s Guide to Trading Options

As volatility increases, so do the prices of options.  This is due to the fact that increased volatility means increasing stock price swings, thereby increasing the possibility of the option making money by expiration.

We describe the option model as “like a balloon”, and it is.  As air is pumped in (premium) and the balloon expands it will offer us different trading opportunities at various times in the option cycle.  The premium is a very important part of any trade and cannot be ignored.  There are many ways to measure the premium levels, but you can get a pretty good handle on the level of “fear” in the market by monitoring just one factor, the Volatility Index (VIX).

The VIX is a product of the CME Group and specifically the CBOE.  It is a simple, but extremely important, barometer of the premium levels of all stocks in the OEX.

There is going to be a positive correlation between the stocks that you trade and the VIX.  By correlation, we do not mean that it will either expand or contract tick for tick with the OEX, but there will be enough similarity with individual stocks, (that except in obvious blow off phases of an individual stock), you do not need to worry about checking the volatility in each of the stocks of your portfolio.

Look at the two charts below.  Notice in the first chart the price of the OEX went below 420 on November 15th then four months later on March 15th it went above 420.  So in the four month time period, the OEX price was unchanged.

The second chart of the VIX is for the exact same time period.  Notice that in November the VIX had reached an all time high of 80 when the OEX price penetrated 860, however four months later with the price exactly the same, the VIX had decreased “air” its premium level by more than 50%!

How could this happen?

The answer is simple: market expectation.  In November, the world was in financial chaos, in March, although it was in the same chaos, the market expectation was that the world had become a safer place.

High Volatility Scenario

The first step to trading options is exactly the same as picking our trading opportunity.  We look at the longest time frame we are observing.  We then go to our trading time frame.  We now add an important step.  We check out the level of the VIX.

As a “general” rule, if the VIX is trading above its 200-day moving average we will use strategies that will BUY premium.  We will do this whether the market is breaking out to the upside or downside.  The only time we will use an exception to this rule is when premium is in a blow off phase of the market.  This is a special case and it will be a unique trade.

Generally speaking, the VIX will be above its 200-day moving average when the market is breaking.  A great example of this was the financial meltdown of 2008.  In the first quarter of 2008 the VIX started to climb, as summer approached it really heated up.  Buying air during the first stage of the move worked very well.  In the fall the VIX entered the blow off stage and for some stocks the premium approached infinity.

Note: During a blow off stage of any market, buying premium (long puts or calls, owning “air”) is financial suicide.  The only people buying options are being forced to liquidate positions.  Do not confuse buying premium with buying the market or selling premium with selling the market, they are not the same thing.  Premium levels only deal with the air in the balloon, not price movement.

The next step is to find a stock that meets our criteria for tradability and we check the shortest time frame that we are observing, our trading time frame.  We find it’s in congestion and we are ready to trade.

We choose to trade aggressive; we’re going to buy a double bottom.  The VIX is above its 200-day moving average, but the underlying market is not in a blow off phase, so the appropriate trade in this scenario is to BUY premium.

The Double Bottom – Bullish

We’ve established the current condition of the market: We’ve identified a double bottom (support) and the VIX is above its 200-day moving average.  We can execute several types of trades.

1. We can buy a call outright.  When buying an outright call, you will want to buy the ATM, or the next lower (first in the money) strike.  Buying teenies is generally a waste of time.  A “teenie” is a measure of value representing one sixteenth of one point; the smallest amount by which a security's price could move and the smallest unit of a security that could be traded.  We want to use options that have punch and are highly correlated to a price move.  OTM options, while exhibiting less risk, can easily lose their correlation if the anticipated rally takes longer than expected.
   
   
2. We can buy the ATM straddle: Buy call and put options with the same strike price, same expiration, and on the same underlying – both the call and put are bought long, for a debit; or the ATM strangle: Buy call and put options with different strike prices – normally of equal, but opposite, Deltas.  The options share the same expiration and the same underlying.  A strangle is usually a position in out-of-the-money options.  A long strangle means both the calls and puts are bought long, for a debit.  This trade gives us great potential to an upside price breakout, but if the double bottom does not hold and a downside breakout takes place, we can still cash the trade.  This type of trade has more premium risk but, it has no price risk.
   
   
3. We can sell a vertical put spread – Bull credit spread: The purchase and sale for a net credit of two puts of the same expiration but have different strike prices – buy the lower strike, sell the higher strike.  Again, you will want to use the ATM or the first strike that is in the money.  This spread has no premium risk, and we can win three ways on this spread.  If the price declines by less than the credit we make money.  If price is unchanged we make money, if price rallies we make money.
   
   
4. We can buy an ATM calendar call spread: The simultaneous purchase and sale of a call of the same type – same strike, same underlying – but with different expirations.  In this case, selling a call in the front month and buying a call in the deferred month.  This spread offers time decay on our side with possibility of more air going into the balloon in the second leg.  The beauty of buying calendar spreads is not only that they have unlimited upside potential, but also have limited risk.  Our front leg (premium sell) could expire worthless, and our long calls could explode, giving this spread a double kick!

Typically traders will end up favoring one or two trade types; that’s why we provided a couple of choices here.  This is an individual question to address… which trade works best for your style, risk tolerance, ease of execution, etc.