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The Beauty of V-Trading
By Len Yates – President OptionVue Systems International.
Volatility trading,
called V-trading for short, has two attractive sides. First, there are
always trading opportunities no matter what’s going on in the general
market. More importantly, there are always positions you can take that
place the odds in your favor. I enjoy going to Las Vegas, but the odds
there are definitely not in my favor! That’s why V-trading is better, way
better.
The essence of V-trading is buying cheap options and/or
selling expensive options, typically holding a position until the options
return to fair valuation levels. So why call it volatility-based
trading?
We call it volatility-based trading because of the way we
measure option cheapness or dearness - using implied volatility. An
option’s price implies a volatility level of its underlying asset. A cheap
option implies that the price of its underlying is going to move very
little, while an expensive option implies the price of its underlying will
be very volatile. Typically all the options of a particular asset move to
higher or lower levels of implied volatility (IV) at the same
time.
Just as prices sometimes move to unreasonable extremes, so
does IV. IV that is extremely low compared to its historical level
indicates the options are cheap and you should consider buying them.
Extremely high IV indicates the options are expensive and that you should
consider selling them. Since options are very sensitive to volatility,
trading options on this basis can be lucrative. In situations where
options become way too expensive or cheap, the V-trader obtains a
considerable edge.
Thus the old adage “buy low and sell high”
applies to V-trading just as well as to price trading. In fact, it applies
more reliably to V-trading. A price can range from zero to infinity.
Volatility cannot range that far. The investor can always count on
volatility eventually returning to normal levels after going to an
extreme. This principle is called “the mean reversion tendency of
volatility,” and it is the foundation of volatility-based trading. It may
take anywhere from days to months, but sooner or later it always comes
back. Consider the volatility chart of the stock Best Buy:
Here is an
excellent example of low IV. Current IV is near its 6-year low at 44.8%,
compared to a normal 60% or so. When options are this cheap, the odds
heavily favor the options buyer. For comparison, other well-known stocks
that average 40% IV are Gillette, Wal-Mart, Colgate-Palmolive, and Home
Depot. My personal feeling is that Best Buy is likely to be more volatile
in the future than any of these companies.
So why not let OptionVue
5 help us to take advantage of this opportunity?
Using Trade
Finder, I entered a target of the bell curve centered on today’s price,
72.19 (because I have no projection for the price of the underlying). I
entered 55% for future volatility, indicating that the stock itself would
have an SV of 55%. I then entered a projection date of X3 (the Jun 2002
expiration), and a +15% in the Impl. Volty Chg box. Under strategies, I
selected All Strategies. In goals, I provided capital of $5,000, with
straddles and strangles to be delta-neutral.
I projected both
SV and IV to return to a conservative level of 55% in this time frame,
rather than the more normal 60%. I also chose a rather long time frame to
give it time to return to more normal volatility levels. However, the
Trade Finder will still consider all the longer-term options no matter
what time horizon is chosen. I prefer to use the longest-term options I
can get, provided they have liquidity. Longer-term options have higher
Vega and therefore respond best to changes in IV.
The program’s best
recommendation was a straddle purchase:
Buy 1 Jan04 70 call at
$21.80
Buy 1 Jan04 70 put at $15.80
The expected return for this
position is $1,595, with a probability of profit (PP) of 100%! If
the expected return seems unimpressive, remember that with a straddle or
strangle purchase, as with all option buying, your risk is limited to the
amount of capital invested. You may not have this much peace of mind with
naked option selling, a strategy often employed when IV is high. And as
long as IV returns to normal, you are guaranteed a profit! The Graphic
Analysis shows this investment has excellent prospects, and low
risk:
By using Jan04
options with 722 days of remaining life, you’re giving this investment
plenty of time to play out. You might even say that time is on your side!
(Surely it won’t take that long before we see higher IV
levels.)
This is a “delta-neutral” trade, with an initial delta of
-15.91. It therefore has very little exposure to small price changes in
the underlying. Sometimes the trader has a directional opinion and
deliberately biases his position in favor of the underlying trend. More
often, the V-trader focuses on making money just from volatility, and is
not interested in trying to make money from underlying price
changes.
When buying
options, it makes sense to buy near-the-money, although it doesn’t have to
be a pure straddle (call and put at the same strike) as this trade is.
That way a sharp move in the underlying has a better chance of helping the
position. When that happens, not only does IV normally get a boost, but
the move may drive one of the sides deep in-the-money and give you a gain
just from price movement.
This position has a Vega of 127.4,
meaning that for a 1 point increase in volatility, you should make
$127.40. When implied volatility returns to ~60%, your options will have
expanded to more normal premiums. That would be the time to close the
position. Again, any significant price movement in the underlying would
also help this position. And it would be very reasonable to expect this.
Note in the volatility chart that SV often spikes to 80% or
higher!
While we chose this trade looking for an increase of
15% in IV, the model predicts a 100% probability of profit if IV rises by
just 5%. This is simply a terrific trade!
* Option strategies carry inherent
risk of large potential losses. As such, these strategies may not be
suited to every investor.
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