I can't prove it, but based on countless conversations it seems to me that most traders who are new to options trading start out either:

1. Buying calls and puts (typically the "cheap" out-of-the-money variety), or
2. Selling covered calls against a stock they already own. 

While there is nothing at all wrong with either of these strategies, the fact of the matter is – based on countless other conversations – it seems to me that most of the successful traders that I know of do not focus on buying naked calls and puts or on writing covered calls. Oh sure, they use these strategies from time to time, but that is not how they make most of their money. Most successful option traders I know of develop either,

1. The ability to focus on a particular strategy and get good at it (think George Fontanills and butterflys, think Mike Wade and credit spreads, think Joe Contes and calendar spreads), or
2. They develop the ability to craft a particular option strategy to fit a particular market situation.

Anyone can buy or sell short a stock or index or futures contract. In trading the underlying security a trader is simply long, short or flat. There are no "shades of gray." The real power of options then is the ability to do things, or to take positions, or to take advantage of situations where one would not be able to simply by trading long, short or flat in the underlying security. Let me illustrate what I'm talking about with some examples. 

HIGH VOLATILITY STOCK PLUS LOW IMPLIED VOLATILITY

As any good Optionetics students knows, two of the keys to trading options are:

a.   Learning to understanding volatility in all of its various forms.
b.   Developing the ability to recognize situations that can be exploited.

"Historical" volatility measures the volatility of the underlying security itself and measures the magnitude of the underlying stock or index's tendency to move in price. The more the stock fluctuates in price and the bigger the typical swing, then the higher the historical volatility. Finding high historical volatility is a good way to find stocks that are likely to move far enough in price to allow an options trade to generate a profit.

"Implied" volatility measures the volatility assumption built into the price of the options on a given security. If option traders on the whole are presently anticipating a lot of volatility in the price of a given stock, then implied volatility will be higher than if expectations are presently low. High or low implied volatility tells you whether there is presently a lot or a little time premium built into the options for a given security. In a nutshell, high-implied volatility (based on comparing a stock's present implied volatility to where it has been in the past) indicates a potential candidate for writing options while low implied volatility indicates a potential candidate for buying options.

CASE IN POINT #1: AMAZON.COM

A recent example of the latter situation described above (i.e., a typically volatile stock combined with low implied volatility) is Amazon.com. Chart 1 displays the price action of this stock from November 2005 through last week. A close look reveals a number of large price swings. From 46 down to 30, back up to 50, followed by a plunge to 25 and then a rally back above 43. This is clearly still a stock that can move.

Chart 1 – Amazon.com Daily Prices
(click here for larger view)

Chart 2 displays the implied volatility for Amazon options with 90+ days left until expiration for the past five years. As you can see, recent IV is at the low end of the 5-year range. This suggests that time premium is at a relatively low level in Amazon options and tells us that this could be a good time to buy options on Amazon. But which ones to buy?

Chart 2 – Amazon.com Implied Volatility for 90+ day options (5-Year History)
(click here for larger view)


Using prices dated 2/7/07, one example of a straddle that looked attractive was to buy the July 40 straddle as shown in Figure 1. This trade involves simply buying the July 40 call and the July 40 put, both of which are historically "cheap" by virtue of the fact that there are trading at an implied volatility of 31.5 and 31.4, respectively. To better appreciate this look again at Chart 2. 

Figure 1 – Amazon July 40 Straddle
(click here for larger view)

Let's assume that a trader enters this position with the idea that he will hold it for about three months or so. If you look at the risk curve in green in Chart 3 you will note the following expectations:

• If the stock is exactly unchanged by May 26, the risk on this trade is about -$300. 
• If the stock makes a 1-standard deviation move then the expected profit would be about +$500 on the upside and approximately +$300 on the downside. 
• If the stock makes a 2-standard deviation then the expected profit would be about +$1,700 to the upside and approximately +$900 on the downside.

Chart 3 – Risk Curves for Amazon July 40 Straddle
(click here for larger view)

One might limit this trade to about three months time in order to avoid the negative effects of time decay that will begin to accelerate in the last month or two prior to July option expiration. Any potential losses in the meantime could be reduced if implied volatility were to increase in the meantime. There is of course no way to guarantee that this particular opportunity will ultimately generate a profit. Nevertheless, the point is simply for you to file away the idea that a combination of a highly volatile stock and low implied volatility is always an opportunity worth examining further.

CASE IN POINT #2: LINCARE HOLDINGS (LNCR)

In an article dated 2/2/07 titled "Opportunis Maximum" I discussed a couple of bearish ideas for LNCR based on the fact that both the daily and weekly Elliot Wave counts were suggesting Wave 5 down counts. Almost immediately the daily count turned around to a bullish Wave 5 count. So the obvious question becomes "what do I do now"?  The choices are many. Stick to the weekly Elliot Wave count and hold a bearish trade?  Abandon the bearish side?  Abandon the bearish side and switch to the bullish side?  Trade both sides? Let's take a look at a couple of possibilities.

In Chart 4 you can see that LNCR is also a fairly volatile stock and in Chart 5 you can see that implied volatility for LNCR options is presently low.

Chart 4 – Lincare Holdings Stock Price
(click here for larger view)

Chart 5 – LNCR Implied Volatility for 90+ day options (5-Year History)
(click here for larger view)

For this scenario I examined the possibility of buy a call backspreads. This involves selling a lower strike call (typically one that is in-the-money) and buying a greater number of a higher strike price call option.

Two potential backspreads that looked interesting were as follows:

• Sell 2 August 35 Calls @ 6.40
• Buy 3 August 40 Calls @ 3.20

The other was:

• Sell 1 August 35 Calls @ 6.40
• Buy 5 August 45 Calls @ 1.15

Each of these trades has relative pros and cons. In a nutshell, the first trade has more downside protection if the stock declines in price, while the second trade has greater upside potential if the stock happens to rally. However, what ended up being most interesting was a combination of these two positions as shown below and in Figure 2.

• Sell 3 August 35 Calls @ 6.40
• Buy 3 August 40 Calls @ 3.20
• Buy 5 August 45 Calls @ 1.15

Figure 2 – LNCR "Complex" Call Backspread
(click here for larger view)

• The maximum risk on this trade (barring an even further decline in implied volatility) is approximately -$400. 
• A 1-standard deviation move to the upside will yield an expected profit of somewhere between +$800 and +$1,300, depending on how soon the move occurs. If the stock moves up more than 1-standard deviation then profit potential is unlimited. 
• Lastly, if the stock declines 1-standard deviation, a trader will likely be able to exit with a small profit.

Chart 6 display the risk curves for this trade with a 1-standard deviation range above and below the current price,

Chart 6 – Risk Curves for LNCR "Complex" Call Backspread
(click here for larger view)

In the 2/2/07 article, one of the bearish examples I highlighted was buying the August 45 put at 5.40. So what would it look like if we combined that long put position with the slightly complex call backspread we just discussed? This combination is presented in Figure 3. 

Figure 3 – LNCR Complex Backspread plus Long Put from example in earlier article
(click here for larger view)

Chart 7 displays the risk curves for this combination. As you can see the risk curves closely resemble those of a long straddle. As you can also see this trade has excellent profit potential through May expiration.

Chart 7 – Risk Curves for Combination of LNCR Positions
(click here for larger view)

An increase in implied volatility in the meantime will serve to move all of these risk curves "further to the right," i.e., risk declines and profit potential increases.

SUMMARY

At this point half of the people who are still reading are going, "hmmmm, that's interesting," and the other half are saying, "what the heck was that all about"? Regardless of which category you may fall into, remember that the specifics of these trades are not the main focus. The key is to step back and recognize a couple of main points:

• You first need to be educated enough to know what to look for. In the examples I have shown we are finding high volatility stocks combined with low implied option volatility. This combination of factors can yield any number of excellent trading opportunities. 
• You then need the tools and inclination to examine different ways to play that situation using options.
• Finally, you need the (ahem) fortitude to take action and to deal with the consequences if a given situation does not pan out as you might have hoped.

In that last regard, just remember that a properly constructed option trade can afford you excellent profit potential with minimal risk.

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site