Stocks have been moving dramatically nearly every day. The Dow Jones Industrial Average saw a three-day bull run last week, from around 18,000 to above 22,000. The next day, it fell 700 points.
Who knows where it will be this week?
While this volatility hasn't been great for many 401(k) or retirement portfolios, Money Morning's options trading specialist, Tom Gentile, sees an opportunity. He has an options trading strategy to help you cope with high volatility and high options prices.
This is a great opportunity for traders. You just have to know what you're doing.
Remember, options prices depend on volatility, and volatility is sky high right now.
The CBOE Volatility Index (VIX) is above 60 today. The average for 2019 was 15.39. So it's four times the volatility we had last year.
That's driven options prices way up. Call and put options could be 10 times the price they were just a month ago.
Not only that, but you have to be careful about which options you buy. If the bid-ask spread is high, it means liquidity could be limited. In that case, you might not be able to buy it at the price you want or sell it later on.
But with Tom's help, you'll turn the volatility into profits. We'll show you the three steps to hedge wild market swings. Then we'll show you how to construct a winning trade during these unprecedented times...
How to Trade Volatility
Before revealing the three-step strategy, it is important to understand what is happening in the options market.
We already saw that high volatility means higher options prices. Wouldn't it be better to take advantage of that by selling options? In essence, we are selling volatility, too, because it won't stay as high as it is forever. The market will eventually calm down.
The next concept is setting your favorite investing style on the shelf for a while. Right now, volatility rules. You have to become a volatility trader.
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Don't worry; we don't mean trading exotic derivatives or swaps. It just means trades must be kept short. If you are looking to call the bottom - whether it is this week, next week, or next month - and buy for the long term, then you can look for investments based on technicals or fundamentals.
The third concept is risk control. You cannot just trade the way you did last year - not with the VIX index so high and prices moving so far and so fast in a single day.
If you got all that, then Tom's three steps are not going to be a surprise...
Step 1- Sell options. When volatility is high, you sell. When volatility is low, then you can buy. But the good part is that you can be bullish or bearish by selling puts or calls, respectively.
Step 2 - Keep it short term. Options that expire within 30 days have higher volatilities, and higher prices, than longer options.
Step 3 - Take less risk. You are already taking less risk by trading options because you can put up a lot less money to get the same profit as buying or selling stocks. Your potential losses are limited. And you can - or should - hedge your trades by using options spreads.
Options spreads are strategies in which you buy (or sell) an option on a stock with a certain strike price and sell (or buy) an option on the same stock with the same expiration but with a different strike price.
In this way, the cheaper option partially offsets the cost of the other option. It also provides a hedge against the market going the wrong way by limiting your risk even further.
Now, here's how you can put a trade together that matches this strategy...
How to Trade Options Right Now
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Let's say you believe the worst is over for the stock market. You might sell a put option spread, configured in such a way as to profit when the market rises. A better name for it is a bullish put spread.
The idea is to buy a put with a strike price just below the stock's current price and sell a put with a strike price just above the stock's current price.
Since the put you sell costs more than the put you buy, you start out with a net credit in your account. If the market stays the same or goes up, you keep the entire credit when the options expire. And if the market falls, your risk is the difference between the two strike prices minus your starting credit.
Now, because options that expire in 30 days or less have higher volatilities, you want to make this a short-term trade. This is especially true because we've seen rallies off big bear market lows before that lasted a short period of time before reversing and heading back down.
Don't forget - if you think the market bounce is already over, you can sell a call spread, which will profit when the market falls. Again, your risk is limited to the difference between the strike minus your initial credit.
Action to Take: In times of high volatility, you want to sell options, and the shorter the better. Just remember that hedging with a spread trade will protect you if the market decides to move sharply against you. And the most important advice of all is to trade smart with smaller trade sizes. The market today is not like it was a few months ago, and you want to make volatility your friend, not your adversary.
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