The best time to trade is when your outlook is different from the consensus. And when it comes to options, that outlook must include volatility data, which can often be the best source of profit.
I saw just such an opportunity as we headed into the European Union summit. The volatility being priced in didn’t seem to be appropriate for what could have emerged from the event.
The CBOE Volatility Index (VIX) was at 20 percent, but the implied volatility of short-term S&P 500 Index (SPX) options and SPDR S&P 500 Fund (SPY) options was much less than that. The implied volatility of the SPX and SPY options was pricing in a move of about 1 percent, which seemed much too low to me. The implied volatility of the VIX options and those of the S&P 500 VIX Short-Term Futures Note (VXX) also seemed underpriced.
The reason: A “bad” outcome could have sent the market crashing, while we now know that a “good” outcome was enough to lift the S&P 500 more than 2 percent, which was not surprising. As the summit began, I had this to say:
“But I don’t really expect this market to dramatically calm down, and that is essentially what is being priced into some markets at this point. For those that are bullish but concerned, short-term long straddles or long strangles in the VIX or VXX are also interesting, as both have implied volatility levels well below the recent historical volatility.”
Those straddles and strangles had big payouts for short-term traders. I think we may face a similar situation going into tomorrow’s job report. The implied volatility of the Weekly SPY options, both for this week and next, is about 13 percent. This suggests a daily move of about 0.8 percent, and I again think that we could see a bigger move than that, either up or down.
Such set-ups are very appealing to me. They are short term, have limited risk, and have exposure to both sides of the market.
On the other side of the coin are earnings reports. I say this because the implied volatility of most stocks skyrocket before quarterly releases.
This means the most people buying options in this period are overpaying. The demand for options increases, and traders price in the unknown. The problem is that most of the time they price that unknown too high.
Apple is an interesting example as it heads into earnings toward the end of the month. In the chart below we can see the spike in the orange line that represents the average implied volatility. It spikes for the April earnings and for the October announcement as well. It is also much higher than the actual volatility at the January earnings announcement as well.
— Option Monster