Listed options are undoubtedly one of the most flexible and responsive instruments available to traders. They afford the bellwether latitude in trading for hedging purposes, speculation, and creation of income all of which are completed with adequate control over risks.
In this article we will endeavor to preview listed options strategies with a bias towards volatility and direction market play basics and utters.
Listed options offer the broadest range of options on the best available trading strategies depending on the perceived market status.
In the new section, I discuss some of the more advanced methods, which use both volatility and directional approaches.
Bull and Bear Spreads
A vertical spread is a strategy in which an option trader simultaneously purchases and writes options of the same type (calls or puts), owning them of the same expiration date but having different strike prices.
Bull Call Spread
It is used when a trader feels that the price of the asset will rise by a small amount.
Like in the case of the bear call spread, the trader buys a call at lower strike price and simultaneously sells a call at a higher strike price, while receiving a limited profit and loss exposure.
Bear Put Spread
This strategy is used when a trader expects that the value of the asset will make a small drop further.
The trader purchases a put option, at a higher strike rate, simultaneously the trader writes a put option, at a lower strike rate. As in bull call spread, it limits both possible gains and losses.
Iron Condors
Iron condor is an intricate options trade in which a trader employs equity selling an out-of-the-money call option together with a put option while at the same time buying a further out of the money call and put options at extreme strike prices.
This strategy targets to earn from low volatility, since the values of the inner strikes will only be reached depending on the expiration of the contract’s portfolio.
When to use it: This is very suitable when you sense that there will not be much volatility on the price of the asset and the price will remain range-bound.
Butterfly Spreads
A butterfly spread is a kind of strategy that must be established by acquiring and selling possibilities in a fashion to create a ‘butterfly-like’ form of structure in the value of the options.
One of them is the long butterfly spread where you purchase one call at a low strike price and sell two calls at the middle strike and finally buy one call at a higher strike price.
When to use it: This strategy is perfect for sideways market where the trader expects a very small price change in relation to the underlying asset.
Risk/reward: The maximum large loss takes place if the price moves far from the outer strikes but likely a big gain if the price is near the middle strike at expiration.
Calendar Spreads
A calendar spread comprises of purchase of a ‘back month’ and selling of a ‘near month’ with the same striking price. This strategy is favorable from the aspect of time decay of the near-month option and the behaviour of the underlying commodity.
When to use it: Ideal when applied where one expects low price fluctuation in the short end of the spectrum but expected price fluctuations in the long end of the spectrum.
Managing Risk with Sophisticated Techniques
Controlling volatility with sophisticated programs makes it possible for sizable gains from great price swings while protecting against the risky times with model like volatility skew and VIX.
Volatility Skew
Volatility skew means the premium difference in options’ implied volatility on one side of the strike prices against the other side.
This mostly happens because traders anticipate wider fluctuations at given prices or owing to the state of options supply and demand at different strikes.
How to use it: Holders can change the speculations by seeking undervalued or overvalued stocks by volatility skew so that the traders can justify the chances of high revenues they stand to gain.
Why Volatility and VIX Indices
The VIX index also known as the S&P 500 Total Return Volatility index, captures the implied volatility of the market. It is widely employed to measure the market’s required volatility regarding the future.
How to use it: The VIX is often used to get an insight as whether the market expects increased volatility, in which case the trader will have to adjust his or her option trading strategies. For instance, the formation of high VIX could mean the formation of the straddles or the strangles, low VIX could mean formation of the condors or the butterfly spreads.
Below are our Selected Directional Plays with Options Time Frames:
The concept of market sentiment is well understood in the directional models. Normally call options are used when expectations are high while put options are used when expectations are low.
The signal itself contains elements of analysis and relies on moving averages, Relative Strength Index (RSI) and MACD to capture the predominant trend so that the options play is entered at the correct phase.
Currently popular markets are directional options strategies including; vertical spreads as well as the long calls/puts since their profits depend on continuity of price trends.
On the other hand, in the range-bound markets the more appropriate strategies, like Iron condor or Butterfly spread, which benefits from the market absence of volatility and price fluctuations.
Innovative Portfolios
Volatility can sometimes be misconceived as a phenomenon to be averted hence does not understanding volatility strategies do a lot in many trading conditions.
To measure this, one turns to the Cboe Volatility Index® also referred to as the VIX® index, which was specifically designed to capture the expected volatility of the overall US equity market over the next 30 days by incorporating weighted prices of S&P 500 Index (SPX) call and put options of all strike prices. Under most conditions, the VIX is negatively related to the S&P 500, and investors does expect the VIX to rise as the S&P 500 falls.
Fluctuations in volatility can greatly affect investors, mainly those who have a short time horizon or who have low risk tolerance and usually forced to reconsider the objectives and practices in getting desired assets.
Risk tolerance can also simply be a plain human emotion with those investors who may develop anxiety from fluctuating portfolio value. But as investment managers, we do not perceive volatility in the same way. In our view it is a chance for the improvement of risk adjusted returns or for getting income.
Equities are a form of an asset class and they cannot be immune to market risk and therefore; volatility is permissible. For instance, the measure has been at about 19.50 in average after 1990, which is the VIX Index. Consider this chart from Strategos Research Partners:
The blue bars signify annualized returns of the S&P 500 Index for the whole year.
The maximum intra year drawdown for each year is depicted by red dots. That means while investing in equity markets drawdowns, and as a result volatility is inevitable.
Harnessing Volatility
Through the years, market participants seeking to hedge against negative price moves have been willing to pay a premium for the protection in return to their counterparties.
Aversion to risk among investors, and their tendency to overemphasize volatility in the market, leads to increased demand for, and hence, a higher price for this safeguard, or ‘insurance’.
This implies, in theory, an option buyer is willing to pay more than they should for the protection they are getting.
The question remains: how can investors and investment managers be strategic about volatility?
According to our observation we identify that volatility is utilized in the form of a mechanism called Volatility Risk Premium (VRP).
The VRP is defined as the expected 30-day volatility or implied volatility subtracted by the following 30-day actual volatility.
In the past, we examined same on S&P 500 Index through VIX Index, which showed that VIX Index less next 30 days’ actual volatility on S&P 500 Index registered positive returns more often than not.
For the last 31 years, the referenced VRP on the S&P 500 Index was identified as positive in 336 out of 387 measured sample points or 86.8%.
The following two charts show historical performance of the VRP in S&P 500 until March, 2022 based on the VIX index.
Assembling the Volatility Risk Premium
When we accustom ourselves to volatility risk premium there are several approaches to this market anamoly.
So, let us start by looking at what is called a short put option strategy. A put option provides the privilege but not the necessity to the long (buyer) of the option to sell a security at a specified price (the strike price) within a specified time (the expiration date of the option) in the future to the short (seller) of the option.
This makes the buyer of the option to sell the shares to the seller of the option making the seller of the option to buy the shares.
Covered writing is one of the methods of using put options for stock replacement. The other use of the put option involves selling a put against an underlying cash position, which is known as the cash-secured put write strategy, can increase the returns of an invested portfolio.
FAQ’s
What are mechanical trading systems that are based on volatility?
- Straddles
- Strangles
- Iron Condors
- Calendar Spreads
What measures do I use to decide that volatility is high or low?
Entropy is the amount of uncertainty surrounding the future price movements of the underlying asset; The implied volatility (IV) is preferred over the actual historical volatility because IV represents the market’s perception of the given stock volatility.
What is meant by directional plays in options trading?
Directional plays are made to get paid from the change in the price of the underlying asset up or down.
This is particularly notable through examples of sophisticated directional strategies.
- Bull Call Spreads
- Bear Put Spreads
- Ratio Spreads
- Diagonal Spreads
How do investors decide which side to embrace – bullish or bearish?
Market trend analysis, performance of the underlying assets together with technical or fundamental drivers.
Is applying higher form sustainable?
They can be, especially as they involve more complicated positions; but risk can be managed in order to minimize the danger.
What remedy can assist in managing risk?
Stop-loss orders
Also carrying out positions changes dynamically
There seem to be a lot of risks associated with the different possible strategic alternatives which are entailing hedging with complementary strategies.
What is the maximum loss in a multi leg position and/ or strategy?
Maximum loss also varies with the chosen strategy but in average cannot exceed net premium or margin requirement.
The Greeks have somehow gotten involved in the trading of advanced options as?
The Greeks – price movement or Delta, time decay or Theta, volatility or Vega, rate of change or Gamma – are vital for managing strategies among the Greeks that the Greeks use.
Is it possible to employ the sophisticated tactics in all environments of the market?
Certain strategies are more effective in specific conditions:
- High volatility: Straddles, Strangles
- Low volatility: Iron Condors, Credit Spreads
- Trending markets: Directional spreads
How do keepers of the prices take into consideration the implied volatility?
IV working hand in hand with options premiums, this is because; when the IV levels rises then this automatically makes the premiums to rise thus being more advantageous to the sellers.