“There is a time to reap and a time to sow” – an adage we have all heard before. While it is applicable in many areas of our lives, it is particularly
pertinent to the business endeavor of buying and selling options instruments. Understanding the mechanics of these instruments helps the trader to better
know when it might be time to reap or time to sow different trades.
For several years, we have been in a very strong bullish market environment. As fear of market corrections – or implosions – have diminished, we see levels
of implied volatility go lower and lower across the options marketplace. Why does this occur? Implied volatility is the piece of an options’ premium that
attempts to price in just how far an equity may move in its price during the lifetime of the option. We know that the end point of all options contracts
involves a binary outcome – either the option expires completely worthless or finishes with 100% intrinsic value (material advantage) in the marketplace.
When equities are trading in their own relatively familiar patterns, the options market doesn’t price as much risk in premiums because there is no
expectation of unusual or unpredictable movement in equity prices. When implied volatility is low, options premiums reflect this in lower premium amounts.
When, however, we begin to see more price fluctuation in equities – and concern that this sort of fluctuation may continue and make it harder to predict
just how far an equity may change in price, thus impacting the potential end point of all options across the chain – then levels of implied volatility rise
causing options premiums to rise.
This brings me back to my opening statement regarding reaping and sowing. I can utilize my knowledge of implied volatility to find what I call “opportune
moments” in the marketplace to both reap and sow various trades. One of my favorite trades is the bullish vertical put spread often referred to as the bull
put. It involves selling a put at a higher strike price and purchasing a put at a lower strike price. Both options are in the same expiration series. The
risk in this trade is the difference in strike prices – the spread – minus the credit received upon trade initiation. That credit is the maximum reward in
the trade. As long as the equity remains above the strike of the sold put through expiration, I keep the credit as the profit in this trade. One of the
reasons I like this structure is that it works in multiple trend situations from strongly bullish to mildly bearish. This makes probability of success
higher in this structure than some other spread trades that need more specific types of equity movement to be successful. Since I am selling premium, it
makes sense to “sow” this trade at times when premiums are relatively high caused by an increase in implied volatility.
So far in 2014, the markets are getting off to a rough start. Particularly this week, we have seen pullbacks across all indices. Certain sectors of the
market, particularly retail, have seen each equity fall over 10% so far. The past several days have seen a spike in levels of implied volatility
across the board both in both shorter and longer term options contracts. I believe we may be coming upon an “opportune moment” for the bull put credit
trade. It may be too soon to call a bottom in this pullback so I am in my “shopping list” mentality. I am looking across my watchlist for equities that
haven’t had a fundamental change but have fallen in price in sympathy with the overall market. When a bottoming process starts to occur, I will look to sow
my favorite trade on multiple equities. I have sat in more cash than usual waiting for this opportunity. There is a season for everything – I
think mine is fast approaching!