Volatility trading, called V-trading for short, has two attractive sides. First, there are always trading opportunities, no matter what’s going on in the general market. More importantly, there is always a position you can take that places the odds in your favor. I might enjoy playing in Las Vegas, but the odds there are definitely not in my favor!
That’s why V-trading is better, way better. The essence of V-trading is buying cheap options and/or selling expensive options, typically holding until the options return to fair valuation levels. So why is it called volatility-based trading?
We call it volatility-based trading because of the way option cheapness or dearness is measured – using implied volatility (IV). Each option implies how volatile its underlying is. A cheap option implies that its underlying is going to be very quiet. An expensive option implies that its underlying is going to be very volatile. Typically all the options of a particular asset move to higher or lower levels of implied volatility at the same time.
The important thing is that just as prices sometimes move to unreasonable extremes, so does IV. To implement V-trading you consider buying cheap options, as indicated by a current IV that is low by historical standards. When IV is extremely high, indicating expensive options, you should consider selling options.
Thus the old adage "buy low and sell high" applies to V-trading just as well as to price trading. In fact, it applies even more reliably to V-trading. A price can range from zero to infinity. Volatility cannot range that far. So when volatility does go to an extreme, it is just a matter of time before it returns to normal levels.
Let’s look at a hypothetical volatility chart for XYZ Corporation that exhibits the pattern you would want to see when you are looking for assets exhibiting low IV (the blue line).
The current IV reading of 36.6% (lower-right corner) is near the low of all readings over the past six years. The IV  in the title bar indicates that only 4% of the previous readings are lower than this. That means IV has been higher than this 96% of the time. s reading is Contrast this with the more normal 41-42% over the previous year and a half, nearly five vol points higher than the current reading. Notice also that a reading of 50% or higher is not unusual for this asset and that it had hit 58% within the last three months.
The red line represents the actual volatility of the underlying stock price called statistical volatility (SV), which shows a current reading of 48.3%. The implied volatility of the options is not even as high as the actual volatility of the stock recently!
Now let’s look for a trade to take advantage of this low IV situation, and in this case we will use the TradeFinder built into the OptionVue 6 software. Using a bell curve type target centered on XYZ Corp’s current price ($15.75) looks at every possible p[rice to two standard deviations on either side of the current price (because we have no projection for the price of the underlying).
We will use the long-term average of 50% for future volatility when creating this distribution (indicating that we think the stock will have an SV of 50% in the future). The holding period we will consider will be 30 days from today, indicating that we think that IV may return to normal within the next 30 days or so. We then projected an increase of 5% in Implied Volatility, because we expect IV to move from its current 36.6% level to a more normal 41-42% in the near future.
Providing $1,000 in capital for the trade we will look for straddles and strangles that are delta neutral. The program’s best recommendation was a strangle purchase:
Buy 6 December 20 calls at $0.60
Buy 4 December 15 puts at $1.41
The actual cost of the trade (ignoring commissions) would be $924, and as with any straddle or strangle purchase (or indeed any option purchase) your risk is limited to the amount of capital invested. The expected return for this position is 198%, with a probability of profit 100%. But before you rush in and do the trade thinking this is a trade you can’t lose on, let’s go over exactly what the graph tells us about this trade.
The Graphic Analysis below shows what this investment will look like 30 days from today with increases of 2.5% increments in volatility. The lowest solid line is what the trade will look like at V+0 – that is we are wrong and implied volatility remains the same as today. The highlighted dashed line in the middle is what the trade will look like at every price of the stock if implied volatility does in fact rise the 5% we are projecting.
When implied volatility rises the price of all options, both calls and puts, goes up. That is why this trade has excellent prospects if IV in fact rises 5% in the next 30 days. If that happens, you make a profit at every underlying price of the stock. But notice that if you are wrong and implied volatility stays at current levels, the downside is not that bad. By using the December options with 228 days of remaining life, you’re giving this investment plenty of time to play out if the rise in IV takes a little longer than you originally planned.