Volatility is an important consideration for all option traders. The volatility of the underlying asset is a major influence of the pricing of options on that security. If the underlying security’s price movements are frequently turbulent, the options will normally have higher time value than if the stock is typically a sluggish mover. This is just a byproduct of option writers attempting to maximize the amount of premium they get in exchange for taking the low profit potential and high risk of writing the option in the first place.
Similarly, “implied volatility” is the volatility value produced by an option pricing model when the option’s real market price is fed into the model. It might change depending on trader expectations. Essentially, an increase in volatility increases the amount of time premium built into the options of a particular investment, whereas a decrease in volatility decreases the amount of time premium. This is information that aware traders may exploit.
- When market volatility surges, some investors may get concerned as prices plummet and gyrate.
- Options contracts, on the other hand, may be leveraged to benefit during periods of extreme volatility when others are scared.
- The put credit spread is one such approach that may be utilized to manage unpredictable markets.
Fear and the Stock Market
In general, the stock market declines quickly during a downturn—as anxiety prompts a rush of sell orders—and then slowly recovers. While this is not always the case, it is a good rule of thumb to follow. As a result, when the stock market begins to collapse, option volatility rises—often swiftly. This leads option premiums on stock indexes to soar beyond what would ordinarily be anticipated based only on the underlying index’s price movement.
In contrast, when the slide eventually stops and the market begins to rise again, implied volatility—and consequently the amount of time premium built into stock index options—tends to fall. This results in the creation of a potentially helpful approach for trading stock index options.
The CBOE Volatility Index is the most widely used indicator of “fear” in the stock market (VIX).The VIX index gauges the implied volatility of SPX options (which tracks the S&P 500).1
Figure 1 shows the VIX at the top, the three-day relative strength index (RSI) below it, and the ticker SPY (an ETF that also follows the S&P 500) at the bottom. When the SPX declines, the VIX tends to “spike” higher.
Figure 1: When the S&P 500 declines, the VIX Index (top) tends to “spike” higher. ProfitSource by HUBB is the source.
The Put Credit Spread
When the stock market falls, put prices usually rise in value. Similarly, if implied volatility rises in tandem with the stock index, the amount of time premium built into put options frequently climbs dramatically. As a consequence, a trader may profit from this position by selling options and collecting the premiums when the stock market is poised to reverse to the upside. Because selling naked put options implies taking on significant risk, most traders are understandably unwilling to do so, especially when the market is dominated by negative sentiment.
As a consequence, two things may assist in this situation: an indicator that the selloff is or will soon be over, and the deployment of a credit spread via put options.
To begin with the second point, a put credit spread, often known as a “bull put spread,” is selling (or “writing”) a put option with a specific strike price and concurrently purchasing another put option with a lower strike price. Purchasing the lower strike price call “covers” the short position and limits the amount of money lost on the deal.
The long-sought-after ambition of all traders is to predict when the stock market will reverse. Unfortunately, there is no ideal answer. However, one of the advantages of selling a bull put spread is that you do not have to be completely correct in your timing. In reality, if you sell an out-of-the-money put option (one with a strike price lower than the current price of the underlying stock index), you merely need to “not be horribly incorrect.”
For timing purposes we will look for three things:
- The SPY is now trading above its 200-day moving average.
- The SPY three-day RSI was 32 or below.
- The three-day RSI for VIX was at or above 80 and has since fallen.
When these three occurrences occur, a trader may want to explore put credit spreads on SPY or SPX.
Consider the signals in Figure 1 as an example. On this day, SPY was above its 200-day moving average, SPY’s three-day RSI had recently dipped below 32, and the VIX’s three-day RSI had lately crept down after reaching 80. SPY was trading at $106.65 at the time. A trader might have sold ten November 104 options at $1.40 and ten November 103 puts at $1.16.
As you can see in Figures 2 and 3:
- This trade has a maximum profit potential of $240 and a maximum risk of $760.
- These options are just 22 days away from expiry.
- The trade’s break-even point is $103.76.
To put it another way, this strategy will benefit as long as SPY loses less than three points (or around -2.7%) during the following 22 days.
Figure 2 – SPY 104-103 in November Credit Spread on Bull Puts ProfitSource by HUBB is the source.
Figure 3 displays the risk curves for this trade.
Figure 3: SPY Bull Put Credit Spread risk curves ProfitSource by HUBB is the source.
If SPY is trading over $104 at the end of the 22-day period, the trader will retain the whole $240 credit gained when the trade was placed. The maximum loss would occur only if SPY was worth $103 or less at the time of expiry. If SPY falls below a specific level, a trader may need to act to limit their loss.
The Bottom Line
In this case, the increase in implied option volatility prior to the signal date—as objectively assessed by the VIX index—served two purposes:
- The VIX jump and subsequent reversal indicated that there was too much anxiety in the market, which is generally a prelude to the restart of a continuous upswing.
- The increase in implied volatility also increased the amount of time premium available to SPY option writers.
In these situations, a trader may maximize potential profit by selling a bull put credit spread and taking in more premiums than if implied volatility was lower. The strategy discussed here is not a “system,” and it is definitely not guaranteed to create profits. It does, however, serve as an excellent example of how combining various elements might result in one-of-a-kind trading possibilities for option traders.
This example involved combining the following factors:
- Price development (requiring SPY to be above its long-term average)
- Volatility is high (a spike in the VIX Index)
- increased likelihood (selling out-of-the-money options)
Traders should be on the lookout for opportunities to tilt as many factors—and consequently their chances of success—in their favor as feasible.
Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.
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