Using Volatility To Maximise Your Option Trading Returns
When volatility increases it leads to higher option Premiums
. Knowing this fact, the option trader can use this measure to help decide what type of strategy they should adopt to a potential trade.Volatility should not be used as a stand alone indicator to enter a trade. If the volatility analysis contradicts the fundamental and/or technical view the trader has formed of the Stock, then the trader should not enter the trade on the volatility view alone.
In fact, the volatility analysis should correspond with the view of the stock, and be used as an additional check for confidence in the trade.
Volatility Based options Strategies
Option strategies can be grouped as: Buying (taking) Strategies, Writing (selling) Strategies, and Combination Strategies. All of these strategies have an element of using volatility to help come to a decision on when to trade or not to trade.
With all strategies, whether they involve options, stocks, CFD's, futures or currency, the trader must always bring it back to basics. Many beginners try to over complicate the amount of information they are absorbing.
Therefore, let us try to simplify volatility again.
The general rule of thumb for volatility is to;
Buy low and sell high. All of the following strategies have been further explained in the "option basics" section of this module.
Buying Calls and Puts
The old saying "buy low and sell high" applies to volatility in option trading. No more so than the most basic of option strategies - buying calls or puts.
An option with high volatility will have a higher price value, no matter whether it is a put or a call option.volatility suggests there is greater unpredictability, and therefore, option writers will increase their selling prices to ensure they are making enough return to cover their risk.
Needless to say, an option with low volatility will have a lower price value. With more predictability because the stock/option prices are not fluctuating as much, the value of both call and put options will decrease.
Hence low volatility will usually signify lower option prices.
For trading call and put options, however, it is the change in volatility that is important. When volatility is high, and it begins to decrease significantly, there is a high probability that an options value will decrease as well.
Irrespective of what the stock price may do. In fact, the Stock Price may not move at all, and the option value may still decrease as volatility decreases.
vice versa when volatility is low and it begins to increase significantly. option prices are very likely to begin to rise.
When analysing to buy call or put options, the trader is wise to evaluate the volatility of the option and consider whether it is high or not. Lower volatility would be a more favourable trade.
Selling Calls and Puts (Option Writing)
We have just discussed the phenomenon of how an increase/decrease in volatility will affect the value of an options price. As we had mentioned, option writers will increase the value (relatively) of the price they sell options for when volatility is high.
Therefore, option writers are best to sell options when volatility is high.
Straddle & Strangle
Both the straddle and strangle strategies rely on the Stock Price breaking out in one direction or the other. Sideways moving price action does not suit either of these strategies.
Using volatility will help in the evaluation of when to enter into either of these strategies.
Entering into a long straddle or strangle requires purchasing call and put options. Just as we look for low volatility when entering a standard call or put position, we also look for low volatility when entering into a straddle or strangle.
Short straddle or strangle strategies would require writing the options when volatility is high.
Spreads - Bull Call, Bear Put, Calendar, Ratio
Spread strategies involve purchasing and writing options of varying Strike levels. As such, the trader is not looking for a strong directional move in the underlying to influence a profit on the options.
In fact, with the different spread strategies available, we analyse for differences in volatility for these strategies.
Bull Call and Bear Put Spreads
Because we are buying one option and writing the other, we are looking for different volatility situations. The sold option requires higher volatility while the bought option requires lower volatility.
The bull call and bear put spreads are entered by selling OTM (Out-of-The-Money) strikes. Typically, OTM strikes will have slightly higher implied volatility anyway, so these strategies are helped literally by nature.
OTM strike levels usually have higher implied volatility because traders will price the options higher. There is a greater degree of uncertainty the further OTM the strike prices are.
Calendar and Ratio Spreads
Again, due to the nature of the spread strategy itself, and with the general rule of thumb, we are evaluating for differing volatility levels between the bought and the written options.
As above, write options with lower volatility and buy options with higher volatility.
Using volatility for Non-options Trading
Volatility is useful for any trader, not just those using options. By evaluating whether prices are relatively low or high (theoretically), the trader can judge whether or not it is a good time to be entering into a position.
Although a very useful tool for all traders, beginners, at times, tend to use volatility as a means of judging direction. Whether volatility is high or low is not a directional indicator.
There are many other indicators traders can use to evaluate direction. Combining a tested system of analysis to choose a stock likely to make a directional shift, along with analysis of volatility, can boost ones trading strategies.
A falling stock will be analysed for indication that it will continue to trend down, or whether it will reverse its current trend. If volatility were to remain stable through this downward trend, it suggests market participants are not too anxious about the direction.
However, if volatility were to rise during a falling market, this shows there is increased uncertainty and investors fear further bearish activity. This is a greater sign that there may be continued downwards movement.
Analysing volatility along with volume is an important tool to use. When there are unexpected spikes in option volume along with spikes in volatility activity, it suggests there are strong possibilities of extreme market movements.
A great example of this is when a share price is rising towards a resistance and begins to consolidate. If Put option volume activity increases along with an increase in volatility, this could suggest there is fear in the market that it might stall and reverse. Traders are purchasing Puts, represented by increased volume.
Using volatility for Day -Trading Ranges
Day traders need to think fast. They must have proven trading plans ready to be activated in a split second.
Volatility is extremely important to those trading plans. traders will evaluate the expected daily trading range of stocks, calculating the standard deviation to statistically ascertain "confidence periods" for the price movements.
By establishing the daily range expectation, the day trader can use these levels to establish entry and exit points for the day.
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