I have written many times about using volatility as an edge when trading options. One of the most attractive things about options is that there always seem to be opportunities to trade volatility. In many ways it is no different than trading stocks. You want to buy low and sell high (or sell high and buy low). The main difference is that, because volatility is mean-reverting, it is much easier to identify high and low situations.
In the current market environment, options are expensive. That is just another way of saying that implied volatility (IV) is higher than it has been in the recent past. The first step to selling high volatility is to find assets whose current implied volatility (IV) is much higher than usual, relative to it past history. I used the Survey feature in OptionVue 6 to quickly scan all stocks looking for those with the highest IV Percentile (which means that the current IV is higher than all, or at least most, of the past readings).
For those readers that do not own software with a similar capability, a more limited way to identify potential candidates would be to use the free OpScan feature in the DiscoverOptions Trading tools. Run the stock volatility report and looks for stocks whose current IV is much higher than the low for the past 500 days.
One of the first stocks that caught my eye was Apple Inc (Symbol: APPL). From the Volatility Chart below (Figure 1), it is easy to see why. Its current IV is near an all-time high. Even better, its current IV is also running way above the actual volatility of the stock, measured by statistical volatility (SV).
Figure 1: Volatility Chart for Apple Inc
Looking at the Matrix (option chain) for Apple, I began experimenting with how these overvalued options might be sold. With the stock at 164.18, one viable strategy would be to sell a strangle – selling 10 of the April 220 calls and selling 10 of the April 125 puts.
The blue shaded area illustrated in Figure 2. This indicates a one standard deviation, and we are selling just outside of that range. That puts the odds in our favor - according to the probability calculator (another free trading tool available on DiscobverOptions.com), the Apple finishing between these two strike prices by the April expiration date is 67.8%.
Figure 2: Option Chain (Matrix) for Apple Inc
This position, as shown in the summary section, would require $16,604 in collateral and would bring in a whopping $7,300. (Note that the $7,300 credit has already been applied to reducing the collateral requirement. Also note that no commissions have been included in these calculations.)
The fact that these options are trading at an IV of almost 63%, while the stock is exhibiting a volatility of nearly 45%, gives this strangle a tremendous edge. If these options were priced at an IV of 45%, where they belong, the calls (currently bid at $3.25) would be bid at only $2.00, while the puts (currently bid at $4.05) would be selling for only $1.75! (I was able to determine this by stepping the Bid price down until I saw a Bid IV of 44.90%). Thus these options are overvalued by almost 2x!
Why not use the nearby options? You could. However, the farther-out options are attractive because of their higher vega, or volatility sensitivity. This higher vega amplifies the effect of the 63%/45% differential, giving us the extra edge. It also means that if IV comes down during the life of this position (very likely), these options will respond better, giving you an early gain.
The favorable terms of this trade are illustrated in the Graphic Analysis of this position shown in Figure 3. The breakeven points (where you neither make nor lose money) are at 117.70 and 227.30. Looking at the price chart for Apple, it is easy to imagine it staying within that range. This is slightly more than a one standard deviation move in either direction (indicated by the shaded area in the graph), and OptionVue 6 calculates the probability of making a profit at 75% (P.P. in the lower left corner of the graph).
What is the risk of this position? With a naked strangle, the risk is that the stock may move too far in either direction, pushing one of the legs into the money. If either leg goes into the money, you should close or adjust your position. One possible adjustment would be to completely close the strangle and open a new one, re-balanced around the current stock price. However, if IV has come down, you might be better off simply closing this trade and looking for another high IV stock on which to write a new strangle.