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How To Profit From A Volatile Market


It is one thing for a trader to state that he anticipates that the markets will become more volatile and it’s another to create a plan to earn money when that volatility prediction turns out to be correct. For example, the immediate question becomes: What is the source of the profits?

The Plan

  • Do you buy VIX calls, betting on a big increase in the price of VIX futures?
  • Do you buy options with lots of vega?
  • Do you buy options with lots of gamma?
  • Do you buy straddles/strangles, playing for either a big market move in either direction or an IV surge?
  • Do you plan to scalp delta when the market moves both up and down with big swings?

I don’t have a simple plan to recommend. Market volatility can manifest in different ways and a trader does not want to own positions that earn little or no profits when correctly predicting the future. It is a situation that is similar to a bullish trader who buys a ton of OTM calls, only to find that the market does not rise far enough or quickly enough to overcome the passage of time and the declining implied volatility of the calls he bought.

 

Possible trade plans

1. Huge market move. It’s fine to place a bet on a big move. If the market were to rally or decline by 10% or more over a relatively short period of time, the option buyer should be able to earn a tidy profit. Buy options that are not-too-far OTM and which that will become reasonablr far ITM if your prediction comes to pass. The options may seem dear, but if you are correct they will provide a handsome profit.

If you also want to bet on the direction of the move, you can save a lot of money by buying only calls or only puts. If you want to plan on a big move, but one that is not large enough for your options to move deep ITM, then consider buying a bunch of OTM spreads. Turning $0.50 or $1.00 into $5.00 is very possible.

If you do not have a directional play in mind, you can buy straddles, strangles, or both put and call spreads. That latter plan is the opposite of owning iron condors.

The risk: When buying premium, the trader has to be correct. If the market move does not occur; or if time passes and IV does not explode; then the options are going to waste away to nothing.

2. IV Explosion. An alternative is to place a wager that IV will move a lot higher than it is right now. That could be the result of a big market decline or simply a result of fear that comes with uncertainty. If you believe America’s dalliance with the fiscal cliff is likely to provide that fear; if you are very bearish for some different reason; if you believe something startling will be announced; then betting that IV will increase is one way to go.

You could buy VIX options, but I must warn you that we have seen big (temporary) IV jumps without participation by VIX options. These options use VIX futures as the underlying asset, and when the market participants see a rising IV but believe that IV will decline again by the time the futures settle, then VIX options do not tend to provide profits for their owners.

You could buy vega. The best way to do that is to own some options with a decent lifetime: perhaps three to six months. If and when IV rises, those options are vega rich and should produce a handsome profit. Obviously you must select options on an asset whose IV rises. The problem is that you have to be right without too much time passing. However, there is a second chance to win. IV may go nowhere, but if the underlying moves far enough in one direction, you could wind up with a very good profit.

A third plan is to buy gamma. Near-term options cost far less than longer-term options and decay rapidly. However, they come with a lot of gamma and if you get the big move, the profits can be huge. This is similar to loading up on vega because in either strategy, you become an option owner. However, the real difference comes in choosing the lifetime of the options. Longer-term options provide vega and shorter-term options come with more gamma.

Then you have the modified plan in which you buy lots of gamma but do not hold for the giant move. Instead, you plan to adjust the position with some frequency (perhaps daily) in an effort to remain near delta neutral but earn profits by selling into rallies and buying on the dips. This works very well when the market moves up and down, but provides disappointing results when the market makes a one-directional move.

3. Bet against the so-called ‘income-generating strategies.’ Sell the iron condor, take a directional stance and bet against the credit spread (by buying the spread); sell ATM calendar spreads or butterfly spreads.

This plan works when the market moves far enough so that the positions produce profits. This is not the ideal plan when you anticipate a huge market move, but works nicely when the market makes frequent decent-sized moves. Not only would you gain from owning the correct delta position, but these trades come with positive vega and there could be additional profits if IV rises.

 

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No real opinion, other than ‘volatility will increase’?

 

That makes it difficult to choose the best play. However, I’d recommend owning some OTM call/put spreads. Clearly you do not want to go too far OTM, nor do you want to pay a high price for the spreads. But there has to be some price that meets your needs.

 

When buying the iron condor and betting against that volatility, we don’t have too much trouble knowing how much premium we must collect to make the trade viable. If your mindset is to take the opposite bet, it should not be too difficult to decide how much to pay to play the game.

The bottom line for me is that I don’t know how to play for the volatile market when I have a generic feeling that volatility is coming. I’d probably choose to own double diagonals. However, if I had a fear that a big rise in market volatility was pending, I would want to own some insurance (if the price is not outrageous) in the form of 5-delta puts and perhaps 10-delta calls. If I had more than a fear; if I were a believer that volatility is coming, I’d exit my traditional plays (for protection) and simply invest a reasonable sum by buying OTM options. As someone who does not trust his market predicting skills, I doubt that I would ever own those options. I would continue as I have been doing, but would trade 50% or less of my normal position size.

This was part of the original request for information:

Quote
I am aware of volatile strategies but need your input as to management, picking the proper ETF or stock (volatile vs. nonvolatile) and your experience with these.

 

Managing risk for any trade involves the same reasoning. the most important factor that goes into a trade is deciding on position size and the maximum possible loss. When you own gamma, risk graphs provide a lot of excitement as we see how much money can be earned. The real danger in those graphs is that they may encourage a trader to overlook the risk of time passing.

The next trick in risk management is to have a good feel for the chances of earning money, and more importantly, setting a profit target. Let me assure you than when the market moves your way and your $5,000 investment has become worth $15,000 and the risk graph shows you how easy it is to reach $50,000 or $200,000, it becomes very difficult to exit. I know someone who bought 2,000 shares of a stock priced in the single digits, saw it rise above $120 and who never sold a share as the stock declined back to the mid teens. In fact, on the decline he bought another 2,000 shares at $40. It is so tempting to believe you are in the midst of the trade of a lifetime and that if you hold out for more, you will get it. I urge you to have a plan.

If you buy low-delta options and IV really moves higher, do not expect them to move ITM. Scale out, or have a price target for selling the whole position. That’s risk management.

The ETF


If you pan to trade options on a specific ETF, be very careful. Do not take a long position in the double- or triple-leveraged products. Yes, they are more volatile than the ‘regular’ ETF, but it is safer to stick with the investment that you understand. The leveraged puppies act differently and are not constructed for anyone other than the day trader.

If you are going to bet on specific stocks, be careful. It is probably better to select a more volatile rather than a less volatile stock or ETF, but it is far more important to buy vega when IV is reasonably priced. If you buy vega on a product with an historical volatility (HV) of 40 when IV is 60, you would be better off paying 30 IV for an ETF with a HV of 30. At last you would not begin with a position that feels as if the premium is already too high. That is also risk management.

I hope this commentary offers enough information to allow you to find a suitable plan to profit if you get that IV hike. I have no recent relevant experience with making this type of play, not having made this wager for decades.

 

 

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