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Playing Offense when Volatilities are Low

David Borun

Back in September when options implied volatilities were falling, we talked about buying low and selling high.


The basic premise was that in a low volatility environment, strategies that involved selling options – especially covered calls – involved more risk and produced less potential income than average.
I also encouraged investors who wanted to protect their long equity position to consider buying out-of-the-money puts during a period of low volatility as those insurance contracts are relatively inexpensive.


That’s a sensible strategy for playing defense and follows the age-old trading logic, “buy when you can, not when you have to.”


But, what if you want to play offense?


In the past two months, option implied volatilities have remained at very low levels and the CBOE Volatility Index fell very close to 12% at the end of last week. Currently it’s trading around 13%.
As stocks continue to hit all-time highs, the number of short bets on CBOE VIX futures and options is also at new highs. When there’s a lot of money piled up in a particular trade, it can be a great opportunity to be a contrarian.


Notably, even as impeachment inquiry gets underway in the House of Representatives, the markets don’t appear to be pricing in much chance of any earth-shattering developments. Everyone seems to assume that the House will adopt articles of impeachment, the Senate will fail to convict the President and the whole thing will disappear from public view.


The VIX is a measure of the average implied volatilities in a basket of near term options on the S&P 500, but because of arbitrage opportunities in simultaneously buying index options and selling options in the individual stocks (or vice versa), when the VIX is low, the vols of individual big-cap stocks tend to fall as well.


The first options trades most traders make is simply buying a call or a put to reflect their respective bullish or bearish opinion on a given stock. Most of the time, I would suggest that as their trading ideas get a little bit more sophisticated, they should consider trading a spread instead in which they both buy and sell options. That way the strategy makes or loses money based mostly on directional movement in the underlying rather than changes in implied volatilities or the passage of time.


When implied vols are low however, simply purchasing options without an offsetting sale can be a wise choice. If you have a strong idea about the likely direction of an individual stock, now is a good time to simply purchase calls or puts that will appreciate if your intuition is correct and the shares move.


Options on electric automaker Tesla (TSLA) are a good example. Since issuing a surprisingly positive earnings report in October,  Tesla shares are up 36%.



Implied volatility in Tesla options that expire in December are around 38%. That’s a lot higher than vols in index options, but it would seem to be on the low side for a stock that sometimes moves that much over the span of just a few days or weeks.


There are a wide range of opinions about the prospects for Tesla’s fortunes going forward. The bulls feel that the company is poised to take advantage of huge first-mover positioning in the electric auto market, potentially becoming the world’s largest automaker.


The bears  - who are licking some considerable wounds lately after losing over a billion dollars in short trades – feel that the current valuation overestimates Tesla’s chances for global success and undervalues the chances of more experienced and deep-pocketed competition, especially from General Motors (GM), Ford (F) and Germany’s Volkswagen AG.

Analyst price targets for Tesla vary widely, from under $200/share to $500/share and higher.


Whichever side of the argument you agree with, now would seem to be a good time to take a position in long options. If the shares take another leg higher or retreat to previous levels and you’re correct about the direction, you’ll be rewarded handsomely, both because of the move itself (delta) and also if implied volatilities rise (vega.)


Professional traders design their positions based on the current level of implied volatilities and so should you.


-Dave


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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

 


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