Another Way to Trade Volatility…

Apple (AAPL) logo …not to mention a way to potentially increase your probability of having a profitable trade (or a trade that loses less) based on statistics.

If you have read my notes on volatility, then hopefully you gathered some ideas on what do when volatility moves to a high or low relative state.

In my opinion, the CBOE SPX Volatility Index (VIX) at 45% represents a relatively high volatility state in the broad market when compared to past observations (being that the average volatility in the S&P tends to fall below 20%). Granted, the recent movements in the marketplace do justify higher-priced options, but some of the questions that need to be asked before you trade are:

Will the markets continue to be volatile?
What direction do you feel the market will move from here?
What are key support and resistance levels?
What sort of news/events may impact my trade?

On Friday, the 10-day volatility of the S&P 500 Index (SPX) was approximately 36% compared to 30-day historical volatility of roughly 26%. The VIX got as high as 48% Friday and settled around 40%, which is higher than the observed movements we are seeing in the S&P 500.

While it is not actually 100% correct to reference the VIX as an exact measurement of the implied volatility of the market, it does give us a broad reference point from which to form a quick opinion and look deeper into individual issues and determine our thesis (the VIX uses all strikes combined in an amalgam of the first two months of expiration to derive its value). What the VIX can do is give you a “free look” at options’ relative cost and compel us to look for strategies on stocks that we know using this data.

For example, on Friday, the VIX was trading at 45%, which seemed high compared to the observed movements in the S&P 500. Because of this comparison and historical market reactions to the VIX at these levels, a trader (either bullish or bearish) might be inclined to be a bigger seller of volatility (net seller of premium). This sentiment was the basis for my search for ways to sell volatility in stocks or in an index. In addition to a trader’s volatility bias, one may believe, that based on valuations (price/earnings) as well as some technical indicators, that the market was oversold in general and relatively cheap, on average, from a valuation standpoint.

For those traders who may disagree with this thesis and want to take a bearish stance on the markets combined with a bullish stance on volatility, I will show you two potential trades to examine – note that these are just examples, not recommendations.

As an options trader, your next step would be to locate a target company or index to trade and choose a strategy and strikes specifically based on your beliefs.

Ratio Spreads in Apple Inc.

One of the stocks worth highlighting is Apple AAPL, which had fallen from $265 on May 13 to $231 on Friday. When trading south of $231, AAPL was below its lower Bollinger band indicating an oversold condition in the stock. AAPL’s 200-day simple moving average was down around $206, which was quite a bit lower. The options prices in AAPL were elevated when compared to the observed volatility of the stock and there appeared to be a fairly high skew to the downside, which means that downside puts were expensive relative to their at the money peers.

Based on these facts, a trader may form a bullish thesis on AAPL with a support level of $200-$206 and a bearish sentiment toward volatility.

The ratio put spread is a strategy that traders can employ when they have a bearish volatility sentiment as well as a moderately bullish or even moderately bearish sentiment on a stock. In the ratio put spread, it’s all about where you place your strikes as well as whether you do the trade for a credit or for a debit.

The ratio put spread (where you sell more puts than you buy, typically two to one) will make the most money when the stock expires right at the short strike. It typically has a short vega sensitivity as well as a positive theta, when done for a credit or when the stock is at or near your short strike, which means that time decay will benefit your position. They are also typically employed out-of-the-money or at-the-money and if done for a credit, can have a higher probability of success, because they may allow the stock to finish in a broad range while still allowing the trade to potentially make money. There is risk to the downside, because essentially what you have is a bear put spread and a short put. The short put means risk in this trade is unlimited down to the zero mark.

A trade tested was the 210/200 ratio put spread, selling two 200 puts to buy one 210 put for a net credit of $1.80. By doing the ratio put spread, you reduce the breakeven in the stock all the way down to $188.20 and unlike the naked short put, you can actually make more than the credit you initially receive at the onset of the trade.

Profit/Loss of Apple Ratio Put Spread

This trade could also be done for a debit, which would require the stock to expire very close to the short put strike and will experience negative theta if the position is out-of-the-money.

Bearish traders with a positive volatility sentiment that believe the stock will drop sharply can examine the put backspread, where more puts are purchased than sold. The backspread has less risk potential, although the maximum loss occurs in a backspread if the stock expires at the long strike. The maximum you can make is the long strike minus spread width minus the total premium paid for the spread. The behavioral characteristics of this strategy will be much different from the ratio put spread, in that it will typically have a positive Vega bias as well as a negative theta (time will be working against you) so be sure and paper trade it first. Another unique risk characteristic is that you may lose more than you pay for the spread, which may seem odd being that most debit trades are limited in risk to premium paid, this is an exception. You will begin to lose more money between your short strike and your long and then begin to lose less as the stock progresses lower, eventually surpassing your breakeven using the formula above as long as the stock continues lower. This can be seen in the risk graph below.

Profit/Loss of Apple (AAPL) put ratio backspread

Whatever strategy you choose, it might be a good idea to enter it into our Profit & Loss Calculator (part of a virtual trading account or as a tool in your real account) and simulate different market occurrences to see what effect they would have on your position. Always ensure you completely understand the risks and rewards of a strategy before employing it with real dollars.

Photo Credit: mrbill

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