When the stock market becomes a roller coaster, the gains and losses both get larger. Traders have the potential to make profits during volatility, but getting it wrong can result in losses. Some traders seek to accelerate their potential gains by trading options during these markets. Options trading is risky, especially during volatility, but these stock market events may present opportunities. Volatility, in some cases, isn’t bad, and it can be used a strategy by some traders’ stock portfolio if they know how to take advantage of it.
Understanding a Volatile Options Market
A volatile market does not mean stock prices always just go down. High volatility sets up an environment with dramatic stock price swings. Assets that normally went up or down 0.5% may see a few days of 2% swings in either direction. Volatility becomes more dramatic for growth stocks with high betas. This combination can result in certain growth stocks rising or falling by 10% in a single day without any additional news items. Low volatility is the complete opposite and results in stock prices staying relatively in place for several days. Traders may encounter a week where the market doesn’t move more than 0.25% in a single day.
Long-term investors get through volatility by ignoring it, but options traders view volatility through two lenses. Historical volatility measures past volatility from selected time frames, while implied volatility offers projections based on recent volatility. Options traders use both of these metrics to gauge how stock prices could react to volatility.
Volatility vs. Risk
Some traders view volatility and risk as two sides of the same coin, but they are actually different. Volatility measures price swings in the stock market. If you do not have any exposure to the stock market, high volatility is not risky. It won’t affect your savings. Investors and traders only incur risk when they buy assets. Every investment, no matter how stable, has a degree of risk. The risk for some investments is missing out on a better opportunity. Certificates of deposit (CDs) provide stable returns, but other asset classes have greater potential for traders.
Investors and traders cannot mitigate volatility. They can’t control volatility, but they can hedge their portfolio against it. These hedges may reduce their risk of experiencing losses from a particular outcome. Buying a put can reduce an investor’s risk in the event stock prices drop 10% in a few weeks. The expiration date on an investor’s put contract also determines the level of protection they have. Volatility will always be a part of the stock market, but you can control how much you risk and how you hedge against certain scenarios.
Choose the Right Strategy
There’s no shortage of options trading strategies and ways to become a better trader. Before committing to any strategy, traders and investors should consider their financial goals and risk tolerance. You don’t want to wake up in the middle of the night in a deep sweat wondering how the market will move at the opening. If you are constantly refreshing stock tickers at premarket and after hours, you may have incurred too much risk.
Adjusting your strategy and lowering your risk can help you feel more confident and reduce anxiety. You should also consider your financial goals. Not all investors want to beat the market. Some investors want stable cash flow from their investments. Options trading can help with both of those objectives, but knowing what you want from your portfolio can help prevent you from making reckless mistakes.
6 Options Trading Strategies to Consider in Volatile Markets
Investors and traders can theoretically profit in any market, and volatility may present an opportunity for a favorable environment, one that may align with investors’ options trading together with their financial goals. Using strategies can help you navigate volatility and sharp movements in options contract prices.
1. Strangle Method
A long strangle strategy can benefit from sharp volatility. A long strangle occurs when a trader buys a call and put with the same expiration date and makes sure they are both out of the money. If the underlying stock moves sharply in one direction, one of the options should appreciate significantly and offset the losses from the option that expires worthless. A short strangle involves selling a call and put that are both out of the money. A trader with a short strangle hopes the underlying stock’s price does not budge. This investor wants the stock price to be within the strike prices of the call and put at expiration instead of significantly above the call’s strike price or below the put’s strike price.
While the strangle method can help your portfolio, it relies on sharp price movements. If the stock’s price stays the same, both options in the strangle will lose value and can expire worthless. A long strangle is not the best options trading strategy for flat and sideways markets.
2. Straddle Method
A straddle is similar to a strangle. When initiating a long straddle, an options trader buys a put and call with the same strike price and expiration. The long straddle holder has the same hopes as a long strangle holder. If the option moves sharply in one direction, the appreciation from one option will offset the other option becoming worthless. Short straddle traders also have the same goal as short strangle traders. They want the underlying stock price to stay flat, so the call and put each lose value.
Just like a strangle, a long straddle’s options will lose value if the stock’s price stays the same or barely moves. Time decay can hurt the position’s value and result in losses. The most you can lose from a straddle is the premiums you pay for the call and put.
3. Iron Condors
An iron condor involves four options contracts. The trader will acquire the following options:
- 1 long call
- 1 short call
- 1 long put
- 1 short put
These options contracts have the same expiration date but different strike prices. The short positions are closer to the money than the long positions. A trader who believes the volatility will smooth out can use an iron condor to potentially profit from low volatility. However, a trader can short an iron condor to take advantage of a high-volatility market. Traders can also start iron condors during low volatility and potentially profit when the stock market becomes more volatile. Higher volatility will increase the iron condor’s value and potentially allow the trader to exit early with a profit.
4. Naked Puts and Calls
Naked puts and calls aim to profit from options expiring out of the money. While you can use covered calls and cash-secured puts, those strategies require more initial capital and or shares, depending on which one you choose. Naked puts and calls don’t have those restrictions but come with unlimited risk. A naked put or call gone wrong can wipe out the gains from other positions and risk falling into debt. Traders using these derivatives hope not to get assigned to these options contracts. High volatility increases the value of these contracts.
Some traders sell far out of the money naked puts and calls to get some premium and a lower chance of getting assigned, but you should be careful when applying this strategy in any market. If a stock price continues, and you have a naked call, you may have to significantly overpay to purchase 100 shares and then give them to the long call holder. A trader can sell an out-of-the-money naked call with a strike price of $100 and watch as the stock’s price soars to $150/share. If the trader sold several naked calls, that trader may be forced to sell other investments to cover the difference. The debt from naked calls can exceed your entire portfolio and potentially wipe out savings. Naked puts and calls are the riskiest options trading strategies and have limited upside.
5. Ratio Writing
Ratio writing occurs when a trader has enough shares to initiate a covered position but ends up selling more calls than they have shares to cover. This can play out if an investor with 100 shares in a stock sells two call options. This can also take place with puts. A trader can short 100 shares and sell 2 puts. Traders can make higher premiums by selling options during high volatility, but they must also consider a strike price that won’t get assigned.
Ratio writing presents the same risks as naked calls and puts. A naked call opens the door to unlimited losses that can potentially wipe out your entire wealth. While not all naked calls have that effect, no trader wants to be the next case study. If you sell a naked put and don’t have enough cash in your account, your broker can sell some of your stocks to buy 100 shares at the strike price. Those forced sales can prompt higher capital gains and force you to part ways with your favorite stocks.
6. Single-Leg Trades
Single-leg trades can be a great way to get started with options trading for certain investors. Instead of buying multiple options contracts to hedge or amplify your position, traders embracing single-leg trades enter a long call, long put, short call or short put. They only enter one position. Low volatility will make options contracts more affordable, and gamma can accelerate an option’s value if market volatility suddenly becomes high. A trader can also consider shorting an option during high volatility to collect a greater premium and then wait for theta and declining volatility to reduce the option’s value.
While single-leg trades can potentially increase your gains, these options quickly lose value if the stock price does not move in the right direction. An options trader buying long calls will see their investment expire worthless if the stock’s price stays the same or decreases. Traders can only predict how the stock market could move, and they can accrue significant losses from single-leg trades if they guess incorrectly.
Navigating Market Volatility
Market volatility may not be bad for all traders, and it’s not synonymous with losses. Options traders who can navigate volatility and align their strategies with their financial goals can potentially make positive returns during high and low volatility. Every day presents traders with new opportunities to hopefully grow their portfolios and learn from mistakes.
Frequently Asked Questions
Which option strategy is best for high volatility?
It depends on your portfolio goals and individual circumstances. Correctly buying a long call or put results in the most gains, but an iron condor can protect you if the high-volatility days cancel each other out. However, an iron condor will lose its value if the stock’s price moves sharply in either direction. A long call or put can expire worthless if the stock’s price moves in the wrong direction or stays the same.
What option strategy can benefit during periods of low volatility?
A long iron condor, short straddle or short strangle can help during low volatility, as long as low volatility doesn’t suddenly give way to high volatility.
Should you buy options when volatility is high?
This depends on each individual’s circumstances. In general, buying options during high volatility makes them more expensive and increases the distance a stock price has to cover to break even. High volatility can generate those movements, but you should consider your risk tolerance first.
About Sarah Edwards
Sarah Edwards is a finance writer passionate about helping people learn more about what’s needed to achieve their financial goals. She has nearly a decade of writing experience focused on budgeting, investment strategies, retirement and industry trends. Her work has been published on NerdWallet and FinImpact.