Trade in Groups

A while back, we demonstrated how high volatility relates to options premiums using a Geometric Brownian Motion (GBM) model. That might sound complicated, but the charts included in that article give a good visual depiction of volatility’s impact, so check it out. For a more simple explanation of why options are currently so valuable, consider this article from Bloomberg. Because many of the largest options market makers no longer have the capital to provide the same amount of liquidity, institutional volume in the options markets has declined. In simpler terms, supply has declined, while the demand still exists – so prices have moved higher, and individual investors have the flexibility to exploit these opportunities.

How can an options trader capitalize on this? The input in options pricing formulas that is above-average is implied volatility, so a willingness to sell IV (by being short puts or calls) may be a method to earn excess returns. Executing a short straddle is a way to sell this volatility in an options trade, earning profits if realized volatility is lower than anticipated in the underlying.

For example, the currently $85 strike February call price for the SPY is $2.35, and the put price is $2.89. With the Volatility Index (the VIX) above 43, volatility is certainly high by historical averages. The payoff diagram below shows that the range of profit at expiration ranges from $79.75 to $90.25, compared to a current price of $84.57. This means the S&P 500 can move about 6.2% in either direction, and this trade will still be profitable. 

How does the current situation compare to past levels of volatility? During quieter times, the VIX averaged around 15. If this level was applied to the same options prices, the range of profitability for this strategy would be from $82.90 to $87.10, or approximately 2.5% in either direction.

The high volatility of late has created opportunities not only for stock traders, but for people willing to use the full range of options strategies available to profit in all markets. For more, see the Options Playbook or general options strategies.