Lessons from the Pros


Common Sense

This article shall give six common sense-actions based on both implied volatility and the market’s trend direction. First, bullish scenarios will be looked at and then Bearish ones. Within each scenario there will be three subgroups; i.e. Strongly Bullish, Moderately Bullish, & Slightly Bullish.

The tables in all of the figures follow the same format. Starting on the left, Market Bias, Stock Action, Option Action, the trade Risk, Reward, and in Bold Letters the I.V. reading.

Market Bias Stock Action Option Action Risk Reward Implied Volatility
Strongly Bullish Buy the stock Buy a put (+p) Limited Unlimited Low

Figure 1: Bullish with the low IV

The scenario that matches figure one includes the mindset of a trader who is very Bullish on the underlying yet at the same time wishes to have some protection for the duration of the trade. The re-requisite actions prior to both purchases, stock and put options, is to verify whether the I.V. is low.  It is then that the trader can proceed by simultaneously entering into this protected Bullish position. The fact that he purchased both the stock and the put means that there are no limits to his upside potential. If the stock goes up, the value of the put decreases yet the trader already accepted the cost of the put as a way of insuring the long investment. Nevertheless, if the stock tanks a lot then every penny paid for the put would be viewed as a smart investment.  Figure 1 can be compared to owning a car with the insurance on it.

Market Bias Stock Action Option Action Risk Reward Implied Volatility
Bullish Buy the stock +p and also –c Limited Limited Mid Range

Figure 2: Bullish with the IV in the middle range

In this second scenario the trader is Bullish on the stock, while the I.V. is in its mid range, meaning the options are neither overpriced nor underpriced. The trader chooses to go long on the stock yet he or she does not want to pay from his or her own pocket the cost of a long put. He or she finances the put purchase by selling a call on the same expiry cycle. Please read this article on Collars  for an in-depth explanation of this strategy. In short, the position profit and loss remain within a range because of the two options; both risk and reward are limited.

Market Bias Stock Action Option Action Risk Reward Implied Volatility
Slightly Bullish Buy the stock Sell an OTM call Unlimited Limited High

Figure 3: Bullish with the high IV

Although this strategy is known to everyone as the Covered Call, what is not so well known is that it is the most dangerous scenario out of the three that we are discussing. Let us go over the facts.  The trader feels the underlying over the long term will be Bullish and he or she does not mind holding it during minor pull backs. Therefore, the out-of-the-money (OTM) calls are sold in proportion to his or her stock holding.  Limited premium is received and there is anticipation that the underlying will not go over the OTM call. But what if it does? Could there be a stop loss? Well, if the stop is placed on the underlying and it gets filled the trader is left with a naked call.  Also, there is no protection to the downside if the trader owns the stock.  Take a look at the table in Figure 3 showing what the risk is.

Moving on to the Bearish scenarios; the figure below shows shorted stock and a call that is purchased.

Market Bias Stock Action Option Action Risk Reward Implied Volatility
Strongly Bearish Short the stock Buy the call Limited Limited to 0 Low

Figure 4: Bearish with the low IV

To a novice eye, at first this strategy might look as the most contradictory one.  If a stock is shorted in isolation then the position would carry unlimited risk to the upside; however, due to the long call that “ain’t so.” The short stock gives us  negative delta and the long call gives us positive delta. The long call limits the risk to the upside.

Market Bias Stock Action Option Action Risk Reward Implied Volatility
Bearish Short the stock -p and also +c Limited Limited Mid Range

Figure 5: Bearish with the IV in the middle range

>Figure 5, above, is still a short position because the underlying is the engine. The short put finances the long call which covers the short stock.  So risk is limited to the upside by the long call but reward is limited to the downside due to the short put.

Market Bias Stock Action Option Action Risk Reward Implied Volatility
Slightly Bearish Short the stock Sell the put Unlimited Limited High

Figure 6: Bearish with the high IV

In this last scenario since there is overinflated premium due to high I.V., an ATM put is sold. If the stock goes nowhere the fluff (extrinsic value) of the ATM put goes out. Keep in mind that if there is any intrinsic value, no matter how small, in that ATM put if it is held until expiry the put will become long stock which in turn would make the overall position flat. Short stock and long stock equal no position. The risk is unlimited to the upside and the reward is limited. The key to this strategy is not just selling the put when the IV is high but also put selection.

In conclusion this newsletter explained six common-sense actions that take into account both implied volatility and the market’s trend direction. The point is NOT to look at just the price chart but also to take into consideration the I.V.  Trading options is all about the I.V., leverage and hedging.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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