3 Options Strategies for a Volatile Stock Market
It looked like we were out of the woods coming into December. President Trump met with China’s President Jinping Xi and the two sides reportedly hammered out a sort of verbal truce. Come to find out there’s a lot of confusion surrounding that deal. Making matters worse, the yield curve is on the cusp of inverting, spooking investors that a recession could be around the corner.
A day after rallying on reports of a trade truce, the Dow Jones Industrial Average shed 800 points, the Nasdaq fell almost 4% and the Russell 2000 dropped 4.4%. Ouch.
Even though markets were up big from the Thanksgiving-week decline — something that we weren’t surprised to see, historically speaking — the relentless selling on Tuesday caused plenty of concern. Will we revisit the lows? Embark on a rally into year-end? It’s impossible to say.
But that uncertainty hasn’t stopped option pros from making money. They’re doing it thanks to the versatility of the options market and various strategies investors can use to profit. Stock investors are left with three choices when it comes to trading: Long, short or flat. Options traders can profit from those biases as well by placing directional bets via calls and puts. However, there are other ways to profit, too.
Straddles to Get You Through Volatility
One strategy to use for volatile markets is the straddle. It involves traders buying both a call and a put with the same expiration date and strike price. Some investors may wonder, what’s the point of doing that? It looks like this:
With ABC trading for $65 a share, we need to “straddle” the security by buying 1 $65 put @ $1.10 and $65 call @ $1.00. Total debit equals $2.10, so we need a move of more than $2.10 by expiration.
The straddle trader doesn’t care which direction the security moves in, as long as the move is big. I’ve personally witnessed options pros utilizing this strategy to perfection over the past two months. Because they are taking on two debit trades, the underlying security needs to make a larger-than-normal move to become profitable.
But in a market like this — where the Russell is falling 4% in a day and the Dow is dropping by 800 points in a single session — options traders are getting the massive moves they need. It’s even better because they don’t have to pick the right direction.
That doesn’t mean traders are guaranteed a profit simply for entering the position. Quite the opposite in fact. Tuesday December 4th was a great example where long straddles paid off handsomely. When volatility is at the upper end of its range though, investors can benefit from a decline in volatility by selling straddles. That’s the nice thing about strangles and straddles (more on them in a minute): we can trade the volatility of the underlying security rather than its price.
If You Don’t Like Straddles, Try the Strangle Strategy
Like straddles, the strangle strategy is also a play on volatility. However, the layout of the strategy is different. Instead of buying a call and put with the same expiration and strike, we’re going to widen the strikes. Literally think of the strike prices “strangling” the underlying security. It goes like this:
With EFG trading at $50, we’re going to buy the $48 put option for $0.75 and the $52 call option for $0.70. Our total debit for the trade is $1.45.
The strangle requires a lower net debit than the straddle, but the straddle will likely close in-the-money one way or the other, with the exception of the rare occasion where the underlying security closes directly at-the-money. In the case of the strangle, we need the underlying security to go through the strike price by the net debit amount.
In this case, our breakeven point is $53.45 or $46.55 on expiration. Of course, one big flush or rally could put enough profit in the trader’s pocket to make it worth their while to close the position early. In fact, most strangle and straddle traders do just that.
But because strangles really need a big move, many traders prefer the straddle in the short term. Strangle traders can also consider the reverse iron condor. Instead of buying long calls and long puts, we turn each one into a spread. In the above example, it would look something like this:
Buy 1 $48/$45 put spread and buy one $52/$55 call spread on EFG.
Credit Spreads Amid Volatility
For those that are more comfortable trading levels and directions, they may consider credit trades. This comes in the form of bull put spreads, bear call spreads and cash-secured put trades. Of course, investors can sell naked calls and puts, but that’s rarely advised.
Unlike strangle and straddle buyers, premium sellers are looking for a decrease in volatility. Credit traders are natural beneficiaries of time decay, but in markets like this these strategies can pay off quickly if the traders gets the direction and volatility angles right.
What does that mean?
Say XYZ collapses lower, falling 10% in a single session on no news other than broad market weakness. Shares are hanging near support and are trading with highly levels of implied volatility. We opt to sell some cash-secured puts on the name. In the next session, the broader market has a relief rally and XYZ moves higher.
Not only does the trader have time decay working in their favor, but they got the direction right and implied volatility is falling. This “vol crush” can suck premium right out of this trade and it wouldn’t be unusual to see gains of 40% or more on a day like this.
The downside of course, is we don’t collect two premiums — like we would with a short straddle or strangle trade — and if we’re wrong, we can be in trouble. So while many of these strategies can pay off big time for options pros, they can be downright lethal for novice option handlers.