Aug 14 2008
Implied Volatility and Choosing a Spread
Some people’s garbage is another’s treasure. Make a silk purse out of a sow’s ear…..put lipstick on a pig. You get the picture. But for some reason, most stock and option traders seem to have a bias toward spotting the special situation where a stock price will be moving up in value and try to identify the buy low and sell high strategy. This natural predisposition is probably because most people aren’t interested in stocks that are losing value or in a state of stagnancy. Not so for the intrepid stock option trader! In fact, there are many more stocks that do little or nothing. And an option trader knows how to make lemonade out of these “unattractive” situations. Moreover, stocks that break down and head rapidly south are more likely to make bigger moves and in a shorter time than stocks that are moving up in price.
Take the situation of a sideways to declining market. Most advisors may advise to stay away from the market or go to cash. But to a stock option trader, the slow and gradual downward movement offers an opportunity for an option trader to capture some time premium decay as well as the downward movement of the stock. For example, the sell-write is an excellent strategy here; however, not everyone is in a position to finance shorting a stock as this requires purchase of the full value of the shares. As a cost effective alternative, an option trader can make use of a vertical “bear spread”.
This strategy uses a vertical spread to allow the trader to take advantage of the stagnant to declining underlying stock movement. When constructed properly, the vertical spread will allow for premium collection in a situation where a stock has a slow, consistent, gradual downward movement. But the key to which vertical bear spread strategy to use depends on implied volatility. In other words, does the trader think the stock break down and make a rapid downward plunge or will the stock just drift lower.
For example, if a trader thinks that implied volatility is likely to increase, the trader can set up a vertical spread to capture downward movement in price. An option trader does this by buying an in-the-money put option and selling an out-of-the-money put option against it. The trader expects the stock to go down significantly. However, if a trader feels that implied volatility will decrease or stay relatively flat, the trader can set up a premium capture strategy by construction a vertical spread by selling an at-the-money put option (premiums are highest when ATM) and buy an out-of-the-money put option to protect against a large downside move and a possible assignment. However, in both of these particular strategies, there is some risk to price reversal.
To learn more on the many ways to make profits with stock options, go to www.optionsuniversity.com for a description and schedule of their excellent online courses.
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