Income Trades and Volatility
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Dan Passarelli MarketTaker .com |
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The market is fundamentally different from what it was a year ago. This is evidenced, in no uncertain terms, by looking at both a price chart of any of the major stock indexes and a volatility chart of these same indexes. Prices are higher; volatility is lower. So is it back to business as usual? Maybe. In fact, maybe it is in some ways better.
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Income Trading
Before the market meltdown, income trading was popular among option traders. These once popular option strategies, including credit spreads, butterflies, iron condors and the like, fell out of favor once the market collapsed last year. Why? They just don’t fare well when the underlying instrument is highly volatile. However, when implied volatility is high, it can be beneficial to income trades.
Implied Volatility and Vega
Implied volatility is the volatility component of option prices. As implied volatility rises, options get worth more, helping long option plays but hurting short options. As implied volatility falls, options get cheaper hurting long options and helping the shorts. The incremental effect of the changes of implied volatility on option prices is measured by the greek, vega. In the long run, implied volatility should be about the same as the stock volatility—though in the short-run they can be disparate, sometimes indicating an opportunity. Such an opportunity has existed in the options market for several months now.
Income trades are generally short vega strategies. That means if implied volatility falls, they profit from vega. Right now, implied volatility is above the volatility of all the major stock indexes. Implied volatility isn’t likely to remain above historical. When it comes down, income trades will profit from the short vega.
Balancing Stock Volatility and Implied Volatility
The risk, of course, is that the stock volatility comes back into play and rises up above implied volatility. One big move in the underlying can wreak havoc on an income trade making a potentially modest winner a big loser. Selling when implied volatility high is an essential part of planning a successful income trade. Selling when implied is high can add potential edge to a trade, increasing the payout-to-odds ratio in the trader’s favor.
Traders must watch both the stock’s volatility and the implied volatility of its options. Both involve risk and reward. Neither can be ignored.
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Dan Passarelli is the author of the book Trading Option Greeks and the president of Market Taker Mentoring LLCTM. Market Taker Mentoring provides personalized one-on-one mentoring for option traders. The company website is http://www.markettaker.com.
Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE’s Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, employees of the SEC and Federal Reserve Bank, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC). Dan has been featured on television and radio and has written numerous articles in the financial press. Dan can be reached at dan@markettaker.com. He can be followed on Twitter.
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