Today I'm going to examine in granular detail a moneymaking tool called the loophole trade.
First, any discussion of the loophole trade must involve volatility. Over the past few weeks, we've witnessed wild intraday swings in the market. One day it's down a couple hundred points, closing at or near its lows of the day, and the next it rallies back up those 200 points or more, closing at or near its highs for the day. It's enough to give a trader whiplash.
This market volatility can also cause a great deal of volatility in the pricing of options. For traders looking to buy calls or puts, this makes it challenging to obtain profits, if for no other reason than options are more expensive than usual due to this volatility.
So how does one avoid this volatility? One choice is to simply not trade and instead wait until the markets settle down - but that's not acceptable to me. My mission is to make you money regardless of market conditions. I want to play in the game, not sit on the bench.
What's another choice? Consider the loophole trade. Below, I drill down and comprehensibly discuss why certain market conditions would compel me to recommend one so that you can confidently embrace the power of the loophole trade.
The Two Reasons for a Loophole Trade
The loophole trade is a debit spread. It can be either a call credit or a put debit trade.
Here are two reasons to consider the loophole trade:
- The options you are looking to buy have too much implied volatility and are deemed expensive, and/or...
- To hedge a straight call or put option. Creating a loophole trade reduces the cost of a straight option purchase, thereby reducing your risk in the trade.
Have you ever bought an option on a stock and had the stock move in the direction you anticipated and the option barely move at all?
Even if a day goes by and the stock stays at roughly the same price, you should only suffer a bit of theta, or time-value loss. However, if the option was too expensive to begin with, it could lose more in that situation.
This is why it's important that you learn as much as you possibly can about volatility...
Volatility 101
Volatility measures the rate and amount of change in an underlying investment (stock, ETF, future, etc.), both up or down.
If the volatility of the underlying investment is high, the option is likely to be priced higher than normal. The volatility in the stock is considered its statistical volatility (SV), and you can enter that value into standard pricing models to calculate a fair market value for the options on it.
There are times where the actual price of the option differs from its fair market price. This situation is due to what's called implied volatility (IV). IV is considered the expected volatility or move in the underlying investment and is priced into the options.
For example, if an option that would normally cost $2.80 is priced at $3.70, that extra cost is deemed a consequence of the IV.
IV can be measured and charted on each option, as you can see in the below image.
Here is the implied volatility chart on the Amazon.com Inc. (Nasdaq: AMZN) August15 440C (Call). Note that this is an example trade from many years ago and should not be confused with a live Amazon trade.
Look at the different colored lines that represent different time intervals prior to expiration. I like shorter-term trades so I will highlight the red line, which is the IV with 7-30 days prior to expiration. Its mean price, or the place where it mostly hangs out, is at 23%, but right now (far right of screen) it's higher than normal at 45%.
This very likely means the option could be more expensive as IV, the expected move, is getting pumped into the pricing of the option. That means average IV was low at the 23% area, and then it began creeping up starting June 22.
There was anticipation of a move building on AMZN that was reflected in the IV and likely in the option pricing. Now that it has made a breakout of its consolidation, it has done so on increasing IV.
If you bought these options on Amazon, you'd be doing so at these higher-than-normal prices. This is another reason why you shouldn't chase trades trying to buy call options when this type of price action is happening. You should either wait for it to retrace a bit back to its breakout price, or consider a loophole trade.
Why should a spike in IV concern you? Well, do you want to get in the habit of overpaying for your option? You wouldn't want to overpay for your car or home, so why would you change that mentality when buying options? This is why paying attention to the IV is important.
An Example of Overpaying for an Option
Let me show you an example of paying too much for an option with an above average IV or inflated price.
Again, let's go back to the same example from 2015 I just showed you. Look at AMZN back on the trading days of April 24 and 27:
AMZN had a significant pop up in price following an earnings announcement. I want to emphasize the following two trading days and the pricing on an option here as a warning to investors about trading without looking at IV ahead of time.
Now, some of you are probably thinking, "Why would I buy if the stock has gapped up in price? Don't stocks fill their gaps? If AMZN does too, it will do so by moving down in price."
Believe it or not, there are traders out there willing to buy for fear of missing out on more gains that could happen because of the earnings report. We call this "FOMO" - and it's a dangerous trap.
Take a look at the option for an AMZN May 440C the day of the gap:
The option price reflects the mid-price, or the price between the bid/ask spread, which in this case shows $13.85 per contract.
Go forward just one day and you can see that the stock closed pretty much at the same price it opened the day before - basically unchanged over the two days of trade. AMZN opened at $439 on April 24 and closed at $438.56 on April 27. Now look at what happened to the price of that same option with hardly a change in stock price:
For the option to lose about 37% in a day seems outrageous.
The Volatility Crush
When something like this happens, it's called a volatility crush. The IV gets sucked out of the premium, and even though the stock has hardly moved, the option is suffering right away. Look at the IV chart and it will show you why it's important to keep an eye on this dynamic:
The implied volatility was surging higher going into earnings, meaning IV was getting pumped into the price of the options. After the earnings announcement, even with the stock gapping higher, both that day and the next saw the volatility crush almost to its mean percent range of 25%. Earnings reports only exacerbate the moves and pricing, but that's okay.
I think this is enough for you to digest right now.
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About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.