Volatility levels shouldn’t be the only consideration when deciding which options strategy to trade
High volatility levels can mean higher options prices, but know the risks
Volatility can change drastically from one day to the next
Any veteran option trader will tell you that part of the allure of options strategies is their versatility and flexibility. Bullish and bearish, long-dated and short-dated, those that collect premium and those that require premium outlay up front. How’s an option trader to decide?
These how-do-I-decide strategy questions come up all the time during our weekly trader Q&A webcasts. Here’s one we got during a recent period of market volatility (vol): “At what volatility level would you switch from a long options strategy—buying calls, puts, or vertical spreads, for example—to a short options strategy such as selling puts or put vertical spreads?”
Like most trading decisions, the answer is simple: It depends.
Judging the Volatility Tipping Point
There’s no hard-and-fast formula for trading long versus short options strategies based on the level of implied vol. It depends on several factors, including your own personal risk tolerance.
Let’s start by looking at what might be considered high volatility. Is it when the Cboe Volatility Index (VIX) is above 20—a level seen by some as the toggle point above which investors look to move into relatively safer assets (i.e., switch from “risk-on” to “risk-off”)? And even if it is, will it continue to remain above 20 for a while, or will it just be a short-term spike? Keep in mind that vol tends to be mean reverting, but sometimes a high-vol environment can persist (see figure 1).
FIGURE 1: DOUBLE-EDGED SWORD OF HIGH VOL. Higher volatility generally means higher options premiums, but it’s for a reason—uncertainty. Note there are several periods when the Cboe Volatility Index (VIX—candlestick) rose above 20 (purple horizontal line) and stayed there for a while. Typically, those volatility spikes corresponded with greater fluctuations in the underlying S&P 500 Index (SPX—blue line). Data source: Cboe Global Markets, S&P Dow Jones Indices. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Should you consider changing your options strategy when vol rises? Perhaps. But the change might not be to switch from a long options strategy to a short options strategy. Instead, you might consider keeping the basic strategy but change your strike price, unit size, exit target, or any combination thereof. First, let’s review a few options dynamics.
What Happens When Vol Rises?
A change in vol will affect not just the price of an option but also the risk factors (greeks). Here’s a sample. As vol rises …
|… options prices …||… rise. Higher uncertainty makes options more valuable, all else being equal.|
|… deltas …||… move closer to 0.50 for calls and -0.50 for puts. Options prices are more sensitive to changes in the underlying stock.|
|… the likelihood of an out of the money (OTM) option finishing in the money (ITM) …||… rises. Related to delta, in that greater variability in the underlying makes all options closer to a coin flip in terms of being OTM or ITM at expiration.|
Understanding these dynamics is important when trying to decide whether high volatility might warrant a strategy change.
Options prices are derived in part by the level of expected vol in the market. So when vol is high, options prices are likely to be high. That means you can collect a higher premium by selling options. But that option will have a higher probability of finishing ITM—meaning a higher likelihood of being assigned a stock position at a worse level than the prevailing price.
So for a short put, it could mean being assigned the stock at a higher price than where it’s currently trading.
Digging Deeper: It’s About the “Why”
Although it’s true that in a high-vol environment you could take advantage of short premium strategies, keep in mind that when vol is high it’s usually for a reason. For an index, it could be macroeconomic uncertainty, a Fed meeting, or a big upcoming data release. For an individual stock, it could be an impending earnings release, news item (good or bad), a swirling rumor mill, or something else.
So really the question isn’t about whether you should switch to a short options strategy when vol is high, but more about whether the strategy gives you a better risk/return trade-off. It helps to first understand what’s making vol high.
Earnings are a perfect example. When a company prepares to release its quarterly earnings, it’s understood there will be a price adjustment—up, down, or not much—to reflect the news. The initial reaction is typically followed by an implied volatility crush. For such a one-and-done vol move, instead of a long call, you might consider buying a call vertical spread or even selling an iron condor. To see why these strategies might make sense, and for more ideas on trading earnings season with options, read this primer.
In other words, vol shouldn’t be the only deciding point for a strategy. You’ll have to consider other factors, such as the trend—bullish, bearish, or neutral—and how long you might want to hold the trade.
For example, suppose you have a bullish outlook on a stock, and there’s been a general rise in implied vol with the VIX trading above 20. If your go-to bullish strategy is to buy OTM calls, should you switch to selling OTM puts to try to get more bang for your buck?
That decision should rest partly on your objectives. Remember: Although a short put and a long call are both bullish strategies, the risk profile of each is entirely different (see figure 2).
FIGURE 2: SHORT PUTS AND LONG CALLS: SAME BULLISH BIAS, BUT DIFFERENT RISK PROFILES. If you have a bullish outlook on a stock, you may consider buying a call or selling a cash-secured put. Each has a different risk profile. With the put, your potential max profit is limited to the premium collected, and the max potential loss can be substantial. The long call requires premium outlay up front, but loss is limited to the premium paid, plus transaction costs, while the upside potential is unlimited. For illustrative purposes only.
High Volatility vs. Your Objectives and Risk Tolerance
If your objectives and risk tolerance haven’t changed on that vol spike, there are alternatives to switching from option buyer to option seller. If, for example, you’re used to a specific premium outlay on each trade, you could consider buying a call that’s further OTM. Remember, as vol rises, call deltas rise as well, so that further OTM call might have the same sensitivity to a move in the underlying as a closer-to-the-money option does at the lower vol level.
Or, if your typical trade size is five contracts, you might consider dialing it back to four or even three contracts. Because higher implied volatility means greater expected movement in the underlying, it may be the case that a higher call strike or a dialed-back unit size keeps your risk/return about the same as it was at a lower vol.
But if you decide to switch to an options selling strategy, instead of a naked short put, you might consider a short put vertical. You’ll take in premium up front, keep your bullish outlook, and limit your downside risk to the difference between the strikes in your spread minus the initial premium and any transaction costs.
So although vol is important for an option trader, it shouldn’t be viewed in isolation. Vol can change, sometimes significantly, from one day to the next. This will have an impact on options prices, so it’s best to look at the entire picture—as well as your objectives and risk tolerance—when deciding which strategies to trade.
Are options the right choice for you?
While options are definitely not for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.