Monday, June 11, 2012

Options Traders’ Top Questions Answered

With volatility trading at historic levels, I’ve received quite a few questions about trading in this market. Keep in mind that this market in general has been very good for options traders, but we are in somewhat uncharted territory and just about anything is possible.

It’s tough enough trading when we know the rules, but when they’re constantly changing, watch out. Since 1973, when exchange-traded options first started trading, volatility has not traded at this level. Despite what you may hear on TV and the news, no one has traded through this scenario before. Therefore, you may be right to be skeptical of any expert who claims to have all the answers.

Index Iron Condors

Question: I’ve been trading Iron Condors, mostly on indexes, for several years and have made consistent profits. In September and October, I have given back over a year’s worth of profits. I thought Iron Condors on index products were relatively safe. They don’t feel so safe anymore!

Answer: I’m sorry to hear that you’ve lost a significant amount of your profits; this market has been very difficult for a lot of traders. To date, I haven’t described the Iron Condor strategy in my recent series of articles. The Iron Condor consists of selling an out of the money put credit spread and an out of the money call credit spread.

This article originally appeared on The Options Insider Web site.

For example, with the XYZ Index at 800 you may sell the 640/650 put spread and the 950/960 call spread for a credit of say, 95 cents. If the index is between 650 and 950 at expiration, you keep the full credit. However, if the index closes below 640 or above 960 at expiration, the spread that you sold for 95 cents will be worth $10 and you take a loss of $9.05. Ouch!

Since these spreads are usually done about 45 days prior to expiration, Iron Condor traders usually have positions in two expiration months on at the same time. If the index makes a large move quickly, either up or down, both months can show significant losses. Obviously, the big move in this case was down. The moves were so large and so quick that defensive action was hard to employ.

An Iron Condor is a high-probability, small-profit strategy. Like many other strategies of this type, they work great until they don’t. I know they’re very popular with the trading public, and I’ll be writing an article fleshing out the details and providing some defensive and adjustment strategies. Overall, I’m not a huge fan, although I do use them from time to time when the conditions are right.

Trading in High-Volatility Environments

Question: With volatility as high as it is today, what strategies do you recommend?

Answer: It sounds like you’re making an assumption that volatility is likely to come down. I’d have to agree with that since it can’t stay up here forever � or can it?

To take advantage of this predicted decline in volatility, you want to employ strategies that have a large amount of negative vega. That would include short at-the-money straddles and strangles. The problem with these strategies is that they leave you exposed to large directional moves. One way to mitigate this directional threat is to buy some directional protection, i.e. out-of-the-money strangles.

The combination of the short straddle and long strangle is called an Iron Butterfly and the short strangle and long strangle combination is the Iron Condor. These positions are done for credits and the adjective “iron” refers to the fact that the positions are composed of puts and calls.

There are two other common negative vega strategies that you might want to consider.

The first is the reverse calendar spread, which is just the opposite of the typical calendar spread. In this case you buy the near month and sell the far month. A problem with this position is that the margin requirements are quite large since the short option is not considered to be covered, and therefore is margined as a naked option.

Another strategy is the ratio vertical spread, which involves buying an at-the-money option and selling two out-of-the-money options with all options having the same expiration month. This is best done with calls when you’re not expecting a large upward move and with puts when you’re not expecting a large move to the downside.

The VIX and the Market

Question: In the past, it seems that when the CBOE Volatility Index (VIX) moved up, the market generally rallied shortly thereafter. Is it time to start buying again?

Answer: It is true that in the past, after a spike in the VIX, the market would rally. However, in the current environment while the VIX has certainly moved up, and done so quickly, it has stayed at a relatively high level. Consequently, it’s not yet clear that this is a “spike.”

Even on the assumption that this is a spike, there is some conflicting evidence that perhaps, not enough data is available to make any statistically significant conclusions regarding how the market reacts to the VIX, and if there is a cause and effect relationship. Keep in mind that the VIX has only been around since 1993.

Short Deep In-The-Money Calls

Question: I am short deep-in-the money naked call options. What happens on expiration if I don’t cover them?

Answer: If you don’t cover your naked calls by buying them back, you will be assigned on expiration Friday, and on Monday morning you will wake to find that you have a short stock position. If you had long stock in your account on expiration day, then your stock would be called away, and you would have a flat position on Monday morning.

Keep in mind that you may be assigned prior to expiration day since your options are deep in the money and may not have very much time value. The probability of assignment is much greater if there is a sizeable dividend payable prior to expiration. The only way to ensure that you won’t be assigned is to buy back the calls.

Volatility Skew

Question: With a stock trading at $48, I recently sold some 55 strike covered calls. The expiration was in 31 days. The next day positive news on a phase 2 trial was announced and the stock jumped $3. However the value of the option fell by nearly 30%. How can that be?

Answer: The short answer is that the implied volatility decreased.

It sounds like you’re referring to a biotech stock. It’s generally true that prior to a major announcement of this type the implied volatility gets bid up to extreme levels. After the announcement, volatility usually comes back to the stock’s normal trading range. It’s quite common for novice traders to underestimate the impact of a change in volatility.

I ran some quick calculations on my options calculator and if the implied volatility was 80% before and 50% after the announcement, the option premium would decline from about $2.15 to $1.50 even though the stock price increased from $48 to $51. You can see that the impact of the change in implied volatility easily outweighed the price change of the stock.

That’s why understanding the impact of changes in volatility is so critical when trading options.

Stan Freifeld is an instructor with the Online Trading Academy. To learn more about him, read his bio here

This article originally appeared on The Options Insider Web site.

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