Narach Investment

OPTIONS TRADING STRATEGIES IN A VOLATILE MARKET


Volatile market trading strategies are appropriate when the investor believes that the market would move but does not have an opinion on the direction of the movement of the market. As long as there is significant movement upwards and downwards, these strategies offer profit opportunities. The investor need not be either bullish or bearish; he must simply be of the opinion that the market would be volatile.

Straddles in a volatile market outlook: A straddle is the simultaneous purchase or sale of two identical options, one a Call and the other a Put. To "buy a straddle" is to purchase a Call and a Put with the same exercise price and expiration date; while to "sell a straddle" is the opposite, where the investor would sell a Call and a Put with the same exercise price and expiration date.

An investor with a view that the markets would be volatile would purchase option straddles. A "straddle purchase" would allow the investor to profit from either a bull market or from a bear market.

Here the investor's profit potential is unlimited; if the market is volatile, the investor would profit from both an upward or a downward movement by exercising the appropriate option first and the second option later. Of course, circumstances may occur in which the investor may let the second option expire worthless as the expiration date may have arrived. So, in a bull market exercise the Call; and in a bear market exercise the Put.

The investor's potential loss would be limited. If the price of the underlying asset remains stable instead of being volatile (that is, either rising or falling) as the investor anticipated earlier, then the most he would lose is the initial premium paid for the Options.

In this case, the investor would have two long positions (one for the Call and the second for the Put) and thus two breakeven points. The first breakeven point would be for the Call which is the exercise price plus the premium paid, and the second breakeven point would be for the Put which is the exercise price minus the premium.

Strangles in a volatile market outlook: A strangle is similar to a straddle, except that the Call and the Put options have different exercise prices. Usually, both the Call and the Put are out-of-the-money. To "buy a strangle" is to purchase a Call and a Put with the same expiration date, but with different exercise prices; while to "sell a strangle" would be to write a Call and a Put with the same expiration date, but with different exercise prices.

An investor with a view that the markets would be volatile may also purchase a strangle. A "strangle purchase" allows the investor to profit from either a bull or bear market. Because the options are typically out-of-the-money, the price of the underlying asset must move to greater degree than a straddle purchase to be profitable.

The investor's profit potential would be unlimited. If the market is volatile, the investor can profit from an upward or downward movement in the price of the underlying asset, while exercising the appropriate option, and if need be letting the second option expire worthless. So, in a bull market exercise the Call, and in a bear market exercise the Put.

The investor's potential loss is limited. If the price of the underlying asset were to remain stable, the most the investor would lose is the initial premium paid to establish the options position. Here the potential loss would be minimal, as the more the options are out-of-the-money the lesser the initial premium paid.

In this case, the investor would have two breakeven points as he would have two long positions. The first for the Call, which breaks even when the market price of the underlying asset equals the higher exercise price plus the premium paid; and the second for the Put, when the market price of the underlying asset equals the lower exercise price minus the premium paid.

The Short Butterfly Call spread: Like the volatile positions we have looked at so far, the Short Butterfly position would realize a profit if the market were to make a substantial move. The structure of this spread uses a combination of Puts and Calls to achieve its profit/loss profile; while combining them in such a manner as to limit the profit.

To illustrate this, let's assume the investor is short the Sept 40-45-50 butterfly with the underlying at 45. The investor is neutral, but would want the market to move in either direction. The position is neutral, consisting of two short options balanced out with two long ones. The profit/loss profile of a short butterfly spread looks like two short positions coming together at the center Calls.

The investor would construct this spread by utilizing one short Call at a lower exercise price, two long Calls at a medium exercise price and one short call at a higher exercise price.

The potential gain/loss is limited on both the upside and the downside. Assuming that the investor has built a short 40-45-50 butterfly; the position would yield profit only if the market price of the underlying were to move below 40 or above 50. The maximum loss would also be limited.

The Call Ratio back spread: The Call Ratio back spread is similar in construction to the short butterfly call spread; the only difference is that, the investor would omit one of the components (or legs) used to build the short butterfly while constructing it.

When an investor puts on a Call Ratio back spread, he would be neutral but would want the market to move in either direction. The Call Ratio back spread would lose money if the market sits. The market outlook the investor would have in putting on this position would be for a volatile market, with a greater probability that it would rally.

To put on a Call Ratio back spread, the investor would sell one of the lower strike price and buy two or more of the higher strike price. By doing so, the investor would receive an initial credit for the position; and the maximum loss would be equal to the higher strike price minus the lower strike price minus the initial net premium received.

The potential gains are limited on the downside and unlimited on the upside. The profit on the downside would be limited to the initial premium received when setting up the spread.

An increase in implied volatility would make this spread more profitable; as increased volatility increases a long option position's value. Thus, the greater number of long options would cause the spread to become even more profitable when volatility increases.

The Put Ratio back spread: In combination positions (for instance, the bull spread, butterflies, ratio spreads), the investor can use Calls and Puts to achieve similar, if not identical profit profiles. Like its counterpart, the Put Ratio back spread combines options to create a spread which has limited loss potential and a mixed profit potential.

This spread is created by combining long and short Puts in a ratio of 2:1 or 3:1. In the case of a 3:1 spread, the investor would buy 3 Puts at a lower exercise price and write one Put at a higher exercise price. Of course, the investor may decide to extend this out to six longs and two short or even nine longs and three shorts; it would be of importance to respect the 3:1 ratio in order to maintain the Put Ratio back spread profit/loss profile.

When the investor puts on a Put Ratio back spread; he would have a neutral outlook on the market, but want the market to move in either direction. His expectation in this case would be for a volatile market with a greater probability that the market would fall rather than rally.

The investor would realize unlimited profit on the downside. The two long Puts offset the short Put and result in practically unlimited profit on the bearish side of the market. The cost of the long Puts would be offset by the premium received from the more expensive short Put, resulting in a net premium received.

To put on a Put Ratio back spread, the investor would buy two or more of the cheaper strike price Put options and sell one of the higher strike price Put option. Thus, the investor would usually receive an initial net premium for putting on this spread.

The maximum loss would be equal to the higher strike price less the lower strike price less the initial premium received.

For instance, if the Ratio back spread is 45 days before expiration and considering only the bearish side of the market; an increase in volatility would increase the profit/loss, and the passage of time would decrease the profit/loss.

The low breakeven point indicated would be equal to the lower of the two exercise prices minus the Call premium paid minus the net premium received. The higher of this position's two breakeven points would be simply the higher exercise price minus the net premium.

We would strongly recommend that the investor first study these investment instruments along with the above listed strategies; conduct dry runs with pen and paper; understand the nuances of the dynamics of the underlying security and the connectivity between the various risks that he or she would be taking on during the pendency of a futures or options position held by him. The strategies provided here are academic in nature; and the information should be used by investors who are aware of the risks inherent in investing and trading in options in the equity markets amongst other financial instruments. Narach Investment accepts no liability whatsoever for any loss arising from the use of this website and its contents.