Volatilities Sink, How do we "Buy Low"?

The equity markets nave continued to grind higher since last week’s Know Your Options in which we discussed selling calls against equity holdings when implied volatilities rise.

As you’d expect, the recent rally has option prices falling again, with the CBOE’s VIX trading near 14% on Thursday and barring any unexpected events, will probably continue to trend toward 12% by the weekend.

If we wanted to sell options against our portfolio when vols were elevated – being “greedy when others are fearful” – it would only make sense that we’d also want to buy options when implied vols fall.

Be “fearful when others are greedy.”

First, it’s probably a good time to buy back covered calls. If I sold calls against existing holdings during a market dip, there’s a good chance I now have a profit in both sides of the trade. The shares I was holding have appreciated, but not enough to raise the value of my short calls. The combined effect of the passage of time and a reduction in implied volatility keep the value of the calls lower.

I’ve got a trade with some nice profit in it, I don’t want to be a pig.

Though I might be tempted to try to squeeze the last bit of value out of my short calls as expiration approaches, I also have to consider the possibility of an abrupt rally that I would miss at least part of if my shares were called away.

I’ve heard this possibility referred to recently as the “Twitter Trade” – so named because tweets from President Trump have the power to move the equity markets rapidly. Even in apparently sanguine times, we’ve got to be prepared for unexpected moves of significant magnitude.

Buy Protection?

As stocks rise within striking distance of all-time highs and options volatilities sink, that same “Twitter Trade” philosophy should also apply to buying protective puts. That sudden move could also happen to the downside and it would be nice to own some options if implied volatilities heat up again.

I’d buy options with a strike about 10% lower than current stock prices for individual holdings or about 5% lower for index options. They’re relatively cheap protection if something truly catastrophic was to happen, but they’re also an opportunity for a quick-profit trade if we see a rapid but contained slide to the downside.

If a provocative news item (or tweet) sends stocks rapidly lower, the long puts will appreciate both because of their negative delta and also rising implied volatility. If I think the move is temporary and I’m not concerned about further declines, I can simply sell the puts to close the trade and keep a nice profit.

You don’t have to create complex spread strategies or take a lot of risk to use options to protect and enhance the return from a portfolio of stocks. You simply need to remember the age-old principle of buying low and selling high.

-Dave

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