There are many ways to take advantage of volatility in a sideways or up and down market.
To get any depth on this subject, will require many posts over time. Here is the surface level intro on a couple of strategies.
1. You’ve done your due diligence and want to enter a long position on a stock.
In this case, depending on what sort of price action you expect, you would choose a strike price in the money, at the money, or out the money and an expiration date either on the front end or progressively longer dated.
To take advantage of greater time decay (theta) and a shorter tie up of capital, I would stay on the front side.
The price action of the underlying will be driven by numerous things: dividend dates, legal settlements, acquisitive growth, 10k filing, regulatory action and so on. You have to be aware of all variables in the position to impact your underlying one way or the other.
My thought process on this is:
If I expect strong upward movement of the underlying, then I want to sell front month or weekly in the money put contracts commensurate with the number of shares I want to own.
Generally selling an in the money put will give you a lower break even than buying the underlying outright. In fact, if it doesn’t then I would say something is wrong and not to make that trade. There should always be a premium to gain from you taking the risk of being exercised.
I sold slightly in the money put contracts on TerraForm Global (GLBL) just before Sunedison (SUNE – SUNEQ) filed for bankruptcy.
GLBL had just experienced a sharp downward move as the market was pricing in the bankruptcy of the parent, SUNE. I viewed the Yield Co (GLBL) as a strong investment at a very attractive entry. The entry was so attractive because of the beating GLBL and Terraform Power (TERP) had taken through the SUNE saga.
Immediately I made 20.2% on my invested capital from selling the puts and my break even had thus built in a 20.2% buffer against a downward move once the underlying was exercised. I sold the soonest expiring date and sat back to wait for exercise. I wanted to be exercised.
The next day SUNE declared bankruptcy and the yield co’s spiked. Perhaps I underestimated just how much bad news was priced into the underlying. I definitely underestimated the bankruptcy declaration date. I assumed it would be closer to the option contract expiration and the options would have been exercised by then.
I had an immediate 4% gain on the trade. I viewed the spike as irrational and closed for the 4% net on the trade to wait for a pullback. A pull back has since happened but not as far as I would like. So I wait, collecting premiums on other option writes, as I sift through the exchanges for undervalued companies.
My point with that illustration is I made 4% in one day after repurchasing to close the puts. My initial sale of the puts netted 20% for a monthly contract. Those are not gains to turn your nose at.
There are plenty of people that could not care less about digging for value and simply trade options with the aim to scalp profits on volatility.
2. You are having a tough time finding good value plays that meet your criteria for investment so you are sitting on cash.
I have no problem sitting on cash. In this scenario I am writing options based on probability. Basically I am looking for big implied volatility and net selling deep out the money options against that with strong probabilities of the contract expiring worthless.
The tax implications are more important when holding short term plays. So be aware of that. Doing this in a tax sheltered account can eliminate some of these issues.
That’s enough for you to chew on for one post.
I will pick this up later in the week.
Thoughts and questions?