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If the stock market drops sharply, not everyone involved loses money. Those who are positioned for the decline can make a killing through options trading.
While volatility is a scary word for investors, markets would not move without it. We need a certain amount of volatility to be able to buy low and sell high.
What investors need to do is have a plan to profit when market volatility is high, such as what we've seen over the past few weeks. The CBOE Volatility Index nearly doubled between the end of July and beginning of August.
But selling stocks short is a risky proposition for most investors, especially because the downside risk of loss is unlimited. Even buying stocks can be risky under such extremes of volatility.
That's why we recommend investors look into options trading strategies. Risk is limited, but the profit potential can be double or triple more than both stock buyers and short sellers can hope to earn.
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It is an ideal combination for shorter-term trading in volatile markets.
Remember, some of the biggest profits are made when the crowd panics and you calmly take advantage of the market's mispricing risk.
Today, we'll show you exactly how to do that using Money Morning options trading specialist Tom Gentile's favorite strategy…
How Volatility Makes Options Trading Work
It is no secret that volatility, and implied volatility (IV) in particular, directly affects the price of an options contract. Of course, the strike price and time until expiration are major components, too, but implied volatility is the factor that can change quickly.
And that is what can make us money.
After the big single-day declines in the S&P 500 this month, options prices soared. That's because implied volatility soared too.
Remember, IV tells us how likely the underlying stock is to make a big move. And again, big moves are what make us money, so it makes sense that options would cost more under that condition.
Since Aug. 14, the day the Dow Jones plunged 800 points, the market managed to put together a string of wins. You would expect that most of the big-name stocks would have rebounded nicely as well, and you would be right.
However, their options had very high IV levels, so buying call options would not result in a very good profit potential or risk/reward situation due to their higher cost.
So, how do we make money in this scenario? Tom likes to use something called a "credit spread." Don't worry; it's not as complicated as its name looks. And it has nothing to do with the bond market.
How to Use the Credit Spread to Make Money
A credit spread is simply the purchase and sale of two options on the same stock with the same expiration but different strike prices. It is called a credit spread because when you start the trade, the net cost, omitting commissions, is negative, resulting in money deposited, or credited, to your account.
The idea is to structure it so that both options expire worthless, which means you get to keep the entire credit.
This trade has other names, such as vertical spread, and since Tom suggested puts to take advantage of that market rebound, the trade we will show you later is called a "bull put spread." In other words, it's a bullish spread using puts.
Tom looked at the options prices for S&P 500 SPDR ETF (NYSEArca: SPY) and saw call prices that were near the money, meaning they had strike prices close to the then-current price of the SPY ETF, cheaper than put options at the same strike price. So, rather than buying calls and hoping they go up in value as the market rebounds, he wanted to sell put options.
Buying call options and selling puts express the same market opinion – bullishness – so why not do it in a way that is more cost effective?
Here's exactly how to do it…