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BookingAlpha Option Trading Advisory

Saturday, January 12, 2013

Options strategies for low implied volatility environments

My little experience selling Credit Spreads is that the worst possible market environment for option sellers is a market that slowly and almost stubbornly trades higher and higher. I've said that before. The Indexes go up little by little almost painfully and the volatility, the VIX and with it Options' premium in general go down.

In this low VIX environment Credit Spread sellers find that in order to obtain the same credit they use to, they now need to sell strike prices that are closer to current market price. And by doing that, they (and me) expose themselves to higher risk. If the market threatens their short strike Calls then they try to adjust, and realize the price for the adjustment is not good either, and you can barely go too far out with your new options as the premium is much lower when the VIX keeps falling.

We faced this scenario during the first 4 months of 2012. And boy oh boy, was it painful to trade. It sucked. It was not fun at all. And since then I've been thinking that perhaps selling credit spreads all the time doesn't make much sense, even though you master the technique, there are some market environments where the premium is just not there, being right now one of them.

With the VIX this low it is a good idea to look at Long Vega trades. Where your positions benefit from an increase in Volatility.

(Click on image to enlarge)
This is the VIX as of Friday, January 11, 2013 at market close.
Assuming that it will revert to a higher mean at some point, then we could benefit from some strategies like the ones mentioned below:

I'll use the RUT index as an example. Generally speaking, a VIX that goes higher comes in tandem with a market that goes down.

Debit Put Spread

Buy 860 February Put
Sell 850 February Put
Debit $2.40
Max reward $7.60
Vega: +10.06 (if the VIX goes up just 1%, the position should gain approximately $10 only for that concept. With the VIX at 13.22 a greater than 10% spike (1.32 VIX points, up to 14.54) is totally realistic)
Theta: -1.70

Put Calendar Spread

Sell 820 February Put
Buy 820 March Put
Debit $6.00
Max reward above $13.00 and may increase.
Vega: +47.88 (if the VIX goes up just 1%, the position should gain approximately $47 only for that concept.)
Theta: -1.65

Put Buttefly

Buy 1. 780 February Put
Sell 2. 820 February Put
Buy 1. 860 February Put
Debit $4.48
Max reward around $35.00.
Vega: +13.61
Theta: -1.14

Broken Wing Put Butterfly

Buy 1. 800 February Put
Sell 2. 820 February Put
Buy 1. 860 February Put
Debit $5.38
Max reward around $34.00.
Vega: +26.42 (Greater Vega than the standard Butterfly, at the price of more Theta against us)
Theta: -4.82

All these positions are capitalizing on the relatively low costs of options right now. And they make a bet on the VIX going higher at some point during the next month.

Of course, with these type of strategies the Credit Spread seller needs a change in mentality. Used to wining 70 - 80% of the trades, adopting these new strategies in the arsenal might take some time for mental adjustment because based on pure probabilities you shouldn't be able to win as many trades. But, have much more attractive risk/rewards, and one good winner may offset two or three losers.

I'll try to include them in my trading folks. I'll try.

Take care.

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  1. Nice article. I am thinkin along similar lines. Only a butterfly is too complicated for me, difficult to get in and out plus high comissions. You can achieve similar results with a Diagonal, try the following:
    Sell FEB 13 PUT at 860
    Buy MAR 13 PUT at 890

    only two options involved. The downside? Same as with everything else you mention, ie. positions will quickly loose value in case the grind continues.

    Good luck,

  2. You're absolutely right Jirka. Diagonals also work as they are positive Vega. Meaning they get the benefit of volatility increases.

    Thanks for posting!

  3. Can we use Straddle/Strangle to long Vega?

    1. Sure. Those two are long Vega. Just keep in mind Theta will work twice against you.