Managing Editor’s Note: Today, we’re handing the reins to colleague Larry Benedict – a market wizard and legendary hedge fund manager. Below, Larry reveals one crucial concept you should consider when you’re trading…
I get it…
Maybe you’ve looked at options a million times. But something just doesn’t click.
You remember that when you think a stock’s going up, you buy a call option. And you buy a put option if you think a stock will fall.
Sounds easy, right?
Yet when you’ve put it into practice, things just didn’t work out for some reason.
Perhaps you got the call right on the direction of the stock.
But the option’s value only increased slightly and then went nowhere. Maybe it even then went down!
The frustration, not to mention the lost money, can be enough for new traders to swear off options for life.
But if you grasp one basic concept that I’ll explain today, I hope you’ll be willing to give options another go…
The Missing Piece of the Puzzle
A big reason so many option traders get stuck is because they fixate solely on the price action of the underlying stock.
For example, if they buy a call option and the stock price rallies, they assume the call option will jump in value.
To be fair, the stock price does have a big impact on an option’s value.
But there’s another factor that plays another major part… volatility.
If you buy a call option and volatility starts to fall, the option can lose value even if the underlying stock rallies.
Understanding the role volatility plays is crucial to getting your trade to work.
And to understand volatility, you need to take a step back and look at option “market makers.”
Because they can play a key role in your trade…
Who Are You Really Trading Against?
When you place an option trade, you’re either buying from or selling to someone else. And chances are the person (or entity) on the other side of your trade will be a market maker.
Option exchanges employ market makers to “make a market.”
That means they provide liquidity so that traders like you and me can readily enter and exit their option positions.
They provide this liquidity by quoting prices and volume for the buy and sell sides of call and put options. They do this with all sorts of different strike prices and expiry dates.
And when you enter an order with your brokerage, they often take the trade.
So to really understand the options market, you need to put yourself in their shoes…
Understanding the Market Makers
Say you decide to buy a put option. A market maker will sell it to you. They are effectively offering you insurance on the underlying stock.
You (as the put option buyer) have paid them for the right to offload stock to them at the put option’s strike price.
The more volatile that stock is (or becomes), the bigger the risk the market maker is taking.
And they’ll want to be compensated more for taking on that risk.
The trap for you is if you buy that put option when volatility is peaking…
Say you bought a put option on the S&P 500. A ramp-up in volatility may come from political uncertainty, the outbreak of war, or poor economic data.
If you buy a put option but those events (or the fear of them) fade out, then volatility decreases – along with the value of your put option.
So you might get the direction right. But a drop in volatility could lead to the value of your option falling…
What to Look For
To avoid this, the ideal scenario is to buy an option when volatility is low but increasing.
If the stock heads in the right direction and volatility increases, then you’ve stacked the odds firmly in your favor. And you can likely bank a tidy profit.
Get both wrong, though, and you could see the value of your option fall sharply.
Before I place an option’s trade, I look at the stock’s implied volatility.
I also make sure to check out the CBOE S&P500 Volatility Index (VIX). That way, I can gauge the broader market’s volatility.
The VIX measures the S&P 500’s volatility using index options (both calls and puts). The higher the VIX is tracking, the higher the expected volatility over the coming month.
On the left-hand side of the chart below, you can see the massive jump in volatility off the back of the pandemic…
CBOE S&P500 Volatility Index (VIX)
Source: eSignal
Had you bought a put option right as volatility exploded during peak COVID fear, you could have made eye-watering profits.
However, the same trade just after that peak would have seen the value of your put option vaporize in front of your eyes.
Of course, this is an extreme example given the massive impact that COVID had globally.
But as the chart shows, there have been plenty of volatility swings since.
As an options trader, you always need to be aware of what volatility is doing… and use it to your advantage.
So when you next go to buy an option, start with the price action. You want to get the direction right.
But don’t place your trade until you’ve checked out volatility.
You want to catch a volatility wave just as much as get the stock direction right.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict