How to Take Advantage of a Low Volatility Environment

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	Sunday, March 18, 2012       Visit Our Website | Subscribe | Unsubscribe   Options Tip of the Week  It's all about the opportunities when trading options. When selling options taking advantage of what the market gives you is a necessity. It may sound obvious, but for most options traders it's not. Let me explain. The investor fear gauge, otherwise known as the VIX (Volatility S&P 500), has moved significantly lower since the latest rally took root back on December 19th. In fact, the fear index has lost 40%. But, a bounce looks imminent. As seen in the chart below the VIX is now trading at an area of strong support around 15 and sits in an extreme oversold state. I don't show it here due to a lack of space, but the RSI is oversold on almost every time I follow even the shortest of time frames. The risk is now to the upside. The probability of a reversion to the mean has increased dramatically.   [click for larger image] So, how can we take advantage of the low-volatility environment with the expectation of a reversion to the mean? What options strategy would best fit this type of scenario? Before I get to the strategy let me discuss a few basic tenets of how volatility and options pricing work. When volatility gets crushed (moves lower), the premium or price of the option of an ETF or stock typically moves lower. More fear = higher risk = larger expected move Thus, with VIX trading near its five year lows and in a deep oversold state over various time frames the high-probability trade is to the upside. Remember, just a week ago, the market had its worst day of the year. The Standard & Poor's 500 Index finally touched and even closed below its 20-day moving average, for the first time in 52 trading days. During that lengthy time, the S&P 500 never even touched that moving average. That is the second longest such streak of all time. The only longer one occurred ended on July 14, 1944! There are other, similar "streaks" that the market had been forging - such as not having even one 1% daily decline until last Tuesday. It was also the first "90% down day" this year. All of these "streaks" were in existence because of the steady, slow-motion rise in the market. Again, during this time we have seen the largest the VIX has declined from 25% to 15% over the past several months and with that type of decline we should expect to see higher implied volatility which equates to higher prices. But, the VIX really isn't the best underlying for trading volatility in the options market. There is a much better alternative - iPath S&P 500 VIX Short-Term Futures. VXX is a highly liquid ETN that is designed to provide access to equity market volatility through the VIX. It offers much tighter bid-ask spreads than its counterpart which means that it offers better pricing for self-directed investors, like ourselves. Trade Arena So, now that I have an assumption on where I think the VIX or VXX is headed over the short-term, what type of strategy would I prefer to use? A credit spread, more specifically a bull put spread. The Bull Put Spread This is a strategy that I use often in my Options Advantage strategy. It requires selling put options at a specific strike price while also buying the same number of puts, but at a lower strike price. For example, with VXX trading at roughly $22.00 we want to look at the VXX options chain for April options expiration to see what type of risk/reward best fits our individual investment needs. Even with VIX trading near long-term lows, VXX still offers an implied volatility of 79.47% for the April expiration cycle. An implied volatility that high means that we can sell credit spreads for some very nice premium. For comparison's sake, SPY offers an implied volatility of roughly 15% during the month of April. QQQ - 18%. So, knowing that we can bring in some decent premium using VXX as our underlying we now must decide if we wish to bring in more premium selling a strike closer to the at-the-money strike of 22, or do we prefer to forgo some premium for a larger margin of error on the trade. I prefer the latter. I like to sell options with a 70% or greater probability of success of closing out-of-the-money. With that being said we can go with the 18 strike as our short strike or the 17 strike. I actually like the 17 strike because as you can see in the options chain for VXX above I can sell the 17 strike for $0.25 and buy the 15 strike for $0.05 for a net credit of $.20. Yes, I could sell the 18 strike and buy the 16 strike for a net credit of $0.37, but you must decide if the extra $0.17 cents is worth losing 10% in your probability of success. Again, I prefer to take trade with a higher probability of success. By doing this I have to take on more risk, but my chance of success is far greater. For example, let's say I decide to do the following trade:      Sell to open VXX Apr12 17 puts      Buy to open VXX Apr12 15 puts for a credit of $0.20. If you look at the option chain above you will notice that the Apr12 17 puts have a 84.48% chance of expiring out-of-the-money. The position is currently 26.2% from the short strike of 17. Remember, the goal of the trade is for VXX to remain above the 17 strike through April options expiration. The trade will suffer the most if VXX pushes below the 15 strike.   The Probability of Success - 84.48% The Max Return - credit of $0.20 per contract or 10.0% The Max Loss - is $1.80 per contract Expiration: 33 days Consider paper trading the ideas above. I know you'll learn something. Remember, feel free to email me at optionsadvantage@wyattresearch.com with any questions that you might have regarding The Strike Price or options in general. Kindest, Andy Crowder Editor and Chief Options Strategist Wyatt Investment Research     Articles From Wyatt Investment Research   One Big Reason you Should Love Volatility Check out Andy's video for the best way to take advantage of volatility with one simple trade. more» Five ETFs Yielding More Than 5% Exchange-traded funds aren't a bad place to look for gains. Here are five ETFs that currently offer more than 5% yield. more» Independent Investment Services Wyatt Investment Research provides investment research that is independent of the back door deals and machinations of Wall Street. more» Options Advantage Options guru Andy Crowder has developed a unique income generating options strategy easy enough for the new options trader to use but with solid returns and a win rate of nearly 90% that will attract any experienced options trader. more» Disclaimer & Important Information WyattResearch.com is owned and published by Business Financial Publishing, LLC. Business Financial Publishing is neither a registered investment adviser nor a broker/dealer. Readers are advised that this electronic publication is issued solely for information purposes and should not to be construed as an offer to sell or the solicitation of an offer to buy any security. We encourage you to review our full Email and Disclosure policies. 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