Volatility III

Volatility Part III

Volatility!  Who loves ya baby?   Kojak 
Day traders love volatility as it gives them the opportunity to scalp profits all day long.

Premium buyers (straddles, strangles) love volatility because it provides quick profits as the underlying asset makes a large move.  And if that move is down, there's the bonus payoff of an increase in the implied volatility (IV) of the options.

Alas, not everyone is Kojak and premium sellers usually don't love a volatile market.  It's true that the option premium looks very juicy, making it temping to sell options – but these options carry large premium for a reason – the market has been volatile. 

Prudent premium sellers, including buyers of iron condors, can make money if we remember to be cautious and pay careful attention to risk management.  That means trading fewer options or spreads, not being greedy, and recognizing when it's time to take a loss and find a better trade.

You can estimate the fair value for an option by entering an estimated volatility into an option calculator.

You can look up the historical volatility (20-, 50- and 100-day) of the underlying stock or index.


6 Responses to Volatility III

  1. Antonio 11/12/2008 at 12:59 PM #

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  2. simon 11/12/2008 at 4:52 PM #

    G’day Mark,
    I generally agree with your thoughts on trading ICs and believe in this current market climate with high IVs, it’s safer to downsize or buy alittle protection. However, I have also found high IV with large market drops at times can be used to the advantage of a premium seller. I am talking about reverse gamma scalping in back months. Are you a fan of such techniques?

  3. Mark 11/12/2008 at 5:16 PM #

    When the market declines and there is a substantial IV increase (such as today and yesterday) that really is a good time to sell premium.
    When buying an iron condor, you collect a good premium for both the call and put spreads. Of course, this assumes that your portfolio and comfort zones can stand the additional risk. This is not an appropriate time for increasing risk beyond your usual limits.
    I am not certain of your definition of ‘reverse gamma scalping,’ but I take it to mean that unless you sell call spreads in further out months, when IV rises – and that’s when the market declines – and then try to scalp the trade by repurchasing those call spreads for a profit on a subsequenet rally. This is counterintuitive, but I do think it’s a good idea, and can work when IV is crushed. However, the very wide bid/ask spreads may make it difficult to accomplish right now.
    I don’t trade this way, but I do sell the call spreads when IV increases. The difference is that I don’t buy them back until then get to my ‘cheap’ price. I’m not looking to scalp. But if scalping is part of your trading strategy, I believe this is one way to achieve it. Obviously, it will not be a same day scalp, but patience works on this type of trade because time is on your side.
    I must mention one warning: This is NOT a good idea when selling call spreads that are close to the money. On any rally, the gamma of those spreads would result in a loss. The play for an IV decrease works best with options that are well out of the money, but which still carry sufficient premium.
    Please respond by letting me know if this is what you had in mind.

  4. simon 11/12/2008 at 9:16 PM #

    What you described is pretty much what I have been doing in this market, my comfort zone and strategies are usually very similar to what you mention in your posts. I mention reverse gamma scalping, as in times of high market volatility like we see in current times it can be opportunistic to take smaller profit increments by scalping on the slight IV crushes or price movements. I do this by going many months out to sell a spread FOTM for good premium when IV is in it’s highest percentile, with time on my side I am able to buy back when the opportunity presents, sometimes within a couple of weeks or even a few days. You are correct with the wide bid/ask spreads, fortunately the Oz market does’nt seem to be all that wide, but we have a different set of barriers to deal with. Anyways, this has only been a recent strategy that I have been utilizing and working on perfecting, it is counterintuitive but that’s the beauty of options. I thought it might be some ‘food for thought’ for some of your readers, keep up the good work.

  5. Mark 11/13/2008 at 6:42 AM #

    What I like best about your post is that you have worked out a new idea for trading in the current markets. Being adaptable is part of being successful. Congrats on what appears to be a very workable strategy. Thanks for sharing.
    I’ve already used the ‘sell’ part – but have not thought about scalping because the markets in RUT, especially in further out months, are wide and require patience to trade. It is indeed food for thought. I wish we had narrower markets as you do.
    Just to clarify: The ‘Oz market’ refers to the market in Australia.

  6. simon 11/13/2008 at 5:43 PM #

    That’s correct. It’s only the ASX200 index (XJO) that we can trade options on and also equity stocks. The spreads might be narrower but that’s about it. We have low liquidity, unfavourable margins, crappy trading platforms, limmited strike ranges and excuberant broker fees. When I recently discovered options on the US indices I felt like a kid in a candy store, now if only the AUD would cooperate with the USD so I can exchange my funds without losing too much. Till then, stuck with the ASX.