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. 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 (IV) 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 historical volatility chart for Sonus Networks, which is an excellent example of an asset exhibiting low IV (the blue line). It’s current IV of 48% (the blue line) one of the lowest readings of the past two years. Contrast this with its more normal 58% over the prior years. Notice also that red line representing the stock’s current statistical volatility (SV). With a current SV reading of 55.7%, these options are not even reflecting the current volty of their underlying!
Using the TradeFinder feature from the OptionVue 6 software, I then looked for a specific trade to take advantage of this low IV situation. For my price target I used a bell type target centered on today’s price (because I have no projection for the price of the underlying), using 55% for future volatility (indicating that the stock itself would continue to have an SV of 55%).
For my holding period I entered a projection date of November 18, 2006(45 days from today), because I’m guessing that IV may return to normal within 45 days. I then projected an increase of 10% in the Volatility Change field. This box allows me to express the opinion that in 45 days I expect IV to move from its current 48% level, up close to a more normal 58%.
Finally, I provided $1,000 in capital for the trade, and allowed straddles and strangles to be ratioed delta neutral. I then let the TradeFinder then search using all the available strategies. The program’s best recommendation was a strangle purchase:
Buy 5 April 5 calls at $0.90
Buy 6 April 5 puts at $0.60
The actual cost of the trade (ignoring commissions) would be $810. The expected return for this position is 11%, with a probability of profit 75%. If this probability of profit seems unimpressive, remember that with a straddle or strangle purchase, as with all option buying, your risk is limited to the amount of capital invested.
The Graphic Analysis shows that this investment has excellent prospects if IV in fact rises 10% in the next 45 days. If that happens, you make a profit at virtually every underlying price of the stock. By using April options with 199 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.