Before we look at one older trade and offer you a new one for today, just a word about volatility.
There are a number of ways of measuring volatility and each has its own root and function. The two main measures employed by traders are historical volatility, a measure of price fluctuations over any given period, and implied volatility, a number that purports to tell us what sort of price fluctuations we can expect at some point down the road.
The most popular and widely watched measure of implied volatilty is the CBOE’s VIX, the so-called ‘fear gauge’, that offers an up to date indication of how traders foresee the S&P 500 trading 30 days away.
Subjective and Objective?
The truth about the VIX is that it’s determined in both an objective and subjective manner. Sound strange? The explanation goes like this – in the first place, it’s calculated instantaneously during trading hours by tracking the objectively verifiable prices of a select number of S&P 500 options.
Glad you asked.
It’s not objective because the prices of those same options are set, as are all options, by the floor traders and market makers who fix the bid and ask on them. And let’s face it, the input of those traders is subject to a great variety of factors, including, of course, the standard Black-Scholes regime, but also a number of intangibles, such as the trader’s own sense of counterparty risk at any given moment, the size and risk profile of his open commitments at any given moment, and, let’s face it, even his mood.
So it becomes clear that during a fast-paced decline, like some of those we’ve seen in the last couple of weeks, spreads on S&P 500 options – indeed, all options – will widen considerably – even ridiculously – and remain wide so long as the threat to traders and market makers is perceived as real. When those threats subside, or at the very least are perceived as diminishing, spreads will quickly tighten up.
More on Volatility
Another volatility fact that can help us in our trading is to be aware that once the norms of historical volatility have been breached – as is happening now – they rarely return to customary levels in a hurry. A look at the last six months of VIX chartitude shows that meaningful spikes, like the one seen in late summer, are generally followed by at least a few weeks of elevated volatility numbers.
Take a peek –
In short, the current bout of VIX volatility will likely remain in place for at least the next two weeks or so, before it settles back into a regular pattern in the 12 – 16 range.
And that being said, it behooves us to choose our options strategies accordingly.
Before we resume this line of thought, though, we have one trade to report – a doozy, opened less than a month back in a letter called Chilled by the Weather; Warmed by Hope. The date was December 22nd, and we were urging you to go negative on the transports. Specifically, we recommended you sell the iShares Transportation Average ETF (NYSE:IYT) January 137 PUT for $5.80 and buy two IYT January 133 PUTs for $3.05 each. Total debit on the trade was $0.30.
And what happened?
Dynamite and chocolate, friends.
IYT is currently trading at $124.12 and the options are selling as follows –
The short 137 PUT is going for $13.10, and
The two long 133 PUTs are fetching $8.60 each.
Buy back the former and sell the latter and your profit is a c-c-c-crazy $4.10 on just $0.30 expended. That’s 1267% profit in less than a month.
Let’s look now at a new trade for the week that embodies what we learned above in our BRIEF VIX lesson.
First up, we know that during a period of heightened volatility, purchasing options will be a relatively more expensive affair. And selling them, too, is fraught with danger, as we could find ourselves deep-in-the-money of a short option in no time.
Remember, too, that we expect volatility to remain at heightened levels for some time, as that’s what generally occurs when spikes in the VIX occur. There won’t be any returning to normal in the next few days, that’s for certain.
Narrowing the Focus
That said, if we want to be buyers of (expensive) options, we have to find a way to hedge our trade so we don’t waste valuable resources if the trade goes sour, but still avail ourselves of plentiful returns if we’re right.
And the way to do that, we believe, is with both put and call backspreads.
We’ll delve into the nitty gritty of how these trades are composed in a moment. But before we do, let’s once again digress and reveal the stock we plan to use for the trade.
You’ve no doubt heard of… Netflix (NASDAQ:NFLX)!!!
Take a look at the chart below –
What’s breathtaking about the Netflix chart is the absolutely gluttonous bullish engulfing pattern that appeared midway through last week (in red). This is a heaven-sent message to the stock’s most failthful that NFLX is about to move in a manner that’s indescribably bullish.
So what do we do? Buy, buy, buy!?
Easy, Lenora, easy!
The fact is, for a separate set of technical reasons, we already set up a long-term call backspread on NFLX back in December (see here for details). That’s atrade that will profit handsomely should NFLX burst higher.
What remains for us today, is to initiate a shorter term PUT backspread, that will cost us next to nothing but still afford us a healthy win if NFLX decides to break temporarily to the downside.
And considering the current level of volatility, that’s equally possible.
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Wall Street Elite recommends you consider the sale of one at-the-money NFLX January 29th 119 PUT for $10.30 and purchase of two NFLX January 29th 109 PUTs for $5.60 each. Total debit on the trade is $0.90.
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With kind regards,
Hugh L. O’Haynew