Those who’ve followed us for any length of time know that we’re purveyors of options. We like the money that can be made in the short spans that we make it, and we like the strategic aspect of the game, too. We also value the ability to hedge our bets that options trading affords us.
Best of all, options give us a chance to make the same profits as those who trade large blocks of stock, but with less money down. And who doesn’t like that?
Smart Buyers and Sharp Sellers
But there’s lots more to the options game than meets the eye, and plenty that you won’t read in textbooks – nuggets of advice and wisdom that you can only garner at the foot of a master – or after many long years of experience, and at times the painful repetition of a mistake or two.
As one of those who learned his mistakes painfully, we’d like to take this opportunity to pass on one of those jewels in today’s letter, a bit of advice that may be de rigueur for options professionals and others who’ve been at it for a decade or more, who’ve seen the money come and go and are therefore a lot wiser for it, but that may be new to some of our fresher-faced readers.
And the lesson we want to impart can be summed up in just five words. It goes like this –
Buy time and sell volatility.
Makes sense, no?
OK then. Let’s take it apart a little, the better to understand it.
First, ‘buy time’.
Always important. Options selection is no simple task, but if we’re buying options, the most important factor in that selection process is that we give the trade enough time to work. The corollary, of course, is that if we’re sellers, it’s always advantageous to sell nearer term options, the better to ensure that they expire before going into the money and – heaven forfend! – leave us penniless, washed up like a cod on the Jersey shoreline.
We’ll come back to this shortly.
Second, is ‘sell volatility’.
That is, when a stock is volatile, it’s advantageous to be a seller of options against it. The corollary here is to be an options buyer when volatility is muted. Of course, in both cases one has to employ a strategy that properly hedges against any catastrophic loss while at the same time leaving the chance for a fair profit on the table.
Combining Pithy Trading Adages
If we take the two items together, then we’ll see that the best possible trades in the options game are as follows –
1. Buying long dated PUTS when volatility is historically low, or
2. Selling near term CALLs when volatility is historically high.
Now, you may ask, from where did we slip in that extra bit about PUTS and CALLS? Those items weren’t part of our prior pithy pronouncements.
And you’d be right. We did, indeed, add a PUT and CALL dimension to the package, respectively, when buying long-dated low volatility and selling short-term heightened volatility.
And why did we do that?
Very simply because traditionally volatility reaches historically diminished levels at market tops (intermediate or longer-term tops), thereby demanding the sale of a PUT in those instances. Conversely, outsized volatility readings are always and forever associated with market plunges – like the one we’re currently experiencing – and therefore require the selling of shorter-dated CALLs.
The best way to engage a market in a free-fall (like today’s) is from the side. That is, we have to employ the above described wisdom, but we also have to fashion our trade appropriately, using the right blend of PUTs and CALLs, the correct expiries and, of course, we have to pay close attention to price.
And when we look at price in a market like this, plagued as it is with brontosauran volatility, we come away with one, clear fact – a fact that’s best expressed via real-life examples.
So, consider, the following tidbit –
The spread, or bid/ask differential, on near-term, at-the-money CALLs for the SPDR Dow Jones Industrial Average ETF (NYSE:DIA), more popularly known as the DIAmonds, is $3.80/$4.35.
That’s enormous, friends! And going out-of-the-money just five percent offers the following spread – $0.54/$0.75.
These are CALL options with less than three weeks on the clock, and they make the point concretely. If you buy these things, you’re going to pay through the beak.
The tightness of any spread is a measure of trader uncertainty. In a calm market, bid/ask spreads are a penny or two off. In a wildly fluctuating market like ours, you might see a 20% or 30% (or more) differential in prices. That’s what traders have to do to ensure a profit. Sell for lots and buy for a lot less.
It’s for this reason that it behooves us to be sellers at this juncture, as even bid prices are apt to be rich with volatility hovering at historically elevated levels.
Take a look at a chart of the CBOE Volatility Index (VIX), a popular gauge of volatility for the S&P 500 –
As you can see, we’re not at levels struck during the Chinese market’s ‘Black Monday’ two weeks ago (in red), but we are unquestionably on an elevated level (blue box), and for that reason we should be sellers of short-term CALLs.
But on which stock?
Well, we’re going to pick a company that’s ordinarily already packed with implied volatility, but over these last few weeks has been outright electrified with a dose of the stuff.
That’s right, car maker Tesla Motors (NASDAQ:TSLA) is what we’re driving at, and the chart and trade follow below.
Here’s Tesla –
Tesla stock has been swinging wildly, and her options are richly priced. We’re moving both ways on them – selling near-term PUTs and CALLs to pocket some premium.
Wall Street Elite recommends you consider selling the TSLA September 25th 225 PUT for $2.90 and the TSLA September 25th 262.50 CALL for $3.90, for a total credit of $6.80.
With TSLA currently sitting at $248.17, breakeven for the trade is either $269.30 or $218.20.
And just 16 days in play.
With kind regards,
Hugh L. O’Haynew