- 1998: Volume 7, No. 5 Trading Volatility Using Options

We often get asked how we determine what markets are good for trading options and what strategies are best used in different scenarios. We take no fortune teller approach to options trading, and we do not trade options in every commodity market. "Knowing when to hold 'em and knowing when to fold 'em," holds just as true to options trading as anything else in trading.

Options have their place in trading, just like every other instrument and derivative, but the key to successfully trading options is to know when the best time to buy calls and puts is and when the best time to sell is. This is extremely crucial in maximizing your success. There are three elements to options trading, though most options traders only use one.

The First Element is Price

For a futures or stock trader, this is of paramount importance. Ask any stock trader about a particular stock he owns and he will tell you when he bought it, why he bought it, and for what price. He will cite technical and fundamental reasons for his opinion and will act solely on his own deductions. He will ask himself: Will the price of the underlying (future or stock) be going up or down? He does not concern himself with when, or how the price will move, only the direction. That's it. Take a look at any stock and you will realize that no matter how you slice it, every dollar made or lost playing the stock market directly affects your wallet.

Options are unique for the simple reason that every dollar move up or down in the underlying instrument will not be the same as the dollar movement of the option. This is lesson number one for any beginning trader.

Time is the Second Element

A successful trader must not only be correct on direction, but also unintimidated by the expiration date of the option. Many times you can be right on which direction the underlying instrument will move, but still lose money because your option expired before it was "in-the-money." If a trader is right on direction, but wrong on time, they can still lose. On the other side of the coin, an options seller may be lured into a naked position with the thought of easy money, only to find out that his position and his portfolio are snatched away by a volatile market.

The Third Element is Volatility

This is perhaps the least understood aspect of trading options. Implied volatility is expressed as a percentage and is quite simply an indication of the value of the option. The more expensive an option is, the higher the implied volatility will be. The cheaper an option is, the lower the implied volatility. Measuring volatility over different periods can give a trader the range of volatility. If you traded Crude Oil options, you may wonder why options with the same days to expiration may be priced differently during different times of the year. This is due to the demand factor, or what other traders feel those particular options are worth at that time. In the case of Crude Oil, option prices tend to be higher during the winter months and lower during the summer months. This information tells me that selling option premiums gives a better probability of return on investment than buying option premiums. Does this mean to sell naked options? Absolutely not. There are many strategies to take when selling options at a premium. One way is to sell at-the-money options to take advantage of high premium and buy out-of-the-money options for protection. This is known as a credit spread, as you will take in a net credit for each 1:1 spread done, as the options sold will take in more money than the options bought for protection.

An astute trader needs to look at options volatility measurements each day on each market, much like a meteorologist measures the weather patterns. Our trading team has created a report called Tradefinder which consists of these measurements of each market. Each day, this report ranks markets from 1 to 31. The expensive options are at the top, the cheaper options are at the bottom. The ranking is based on the implied volatility of the options over the last two years. If options are trading near two year highs in implied volatility, it will be at the top of the list, if close to a two year low, it will be at the bottom.

So, we buy low, and sell high. The bottom ranked markets are good for buying strategies such as straight calls and puts, straddles, strangles and synthetic straddles. The top ranked markets are good for selling strategies such as selling puts and calls, short straddles, short strangles, credit spreads, condors, butterflies, ratio spreads, and many others. There is a value indicator and a break out indicator. The value indicator is another way to look at option prices with respect to the movement of the underlying. A value below 100 percent means that those options are relatively cheap for the short-term.

The break out indicator is what we really watch for. This value tells a trader that a consolidation of the underlying price is occurring. Many

times this consolidation looks like a wedge pattern. When this value goes below 50 percent it almost always signals a large move in the underlying price. It doesn't matter if you don't know the direction of the breakout, only that a breakout is likely to occur. Sometimes we will pick a direction, but we have found that a non-directional straddle with 45 days or more to expiration gives the best results.

To summarize, we are always looking to buy undervalued options and sell overvalued options. This puts the edge of winning on our side. When the options are fairly valued and we don't have a directional bias, then we sit aside in that market. Learning how to buy and sell options value will push your trading to a new level as well. Not learning this crucial element to options trading will cause you to rely on the fourth element —luck.

George Fontanills is President of Global Investment Management Corp. and Pinnacle Investments of America, Inc. His seminar series, Optionetics, has been one of the most popular seminars on the market since its inception in 1993. He has just released a new best-selling book, The Options Course—High-Profit, Low-Stress Trading Methods.

Tom Gentile is Chief Options Advisor for Global Investment Management Corp., and a full-time futures and options trader. He writes publications for many magazines and is co author of the book The Options Course—High-Profit, Low-Stress Trading Methods.