The first presentation at the 2nd Annual Asian version of CBOE’s Risk Management Conference featured an informative tutorial from Dan Passarelli of Market Taker Mentoring. Dan’s talk was titled Directional Options Strategies and Trade Management.
He kicked things off with a quick review of the option greeks and then dove into directional strategies. He emphasized that trades can start with a directional outlook, but there are other factors that come into play with respect to an option trade. A factor he specifically notes is and option’s implied volatility. It is very possible for a trader to get the direction correct with respect to the underlying market, but have a trade not work as well as hoped due to a change in implied volatility.
With a focus on volatility as a screen for option trades Dan notes that traders will use screens to identify options that are pricing in low volatility. A recent situation with shares of Facebook (FB) was used as demonstration of an option trade that gains an edge due to low implied volatility. The chart below was lifted from his presentation and it shows that FB 30-day implied volatility is near the lower end of the recent range. This may be interpreted as the options being cheap and with a directional outlook a trader may have an edge through buying an option with low implied volatility.
Dan uses the phrase “How cheap or expensive options are” to describe implied volatility. This means when it is at the low end of a range, traders may refer to an option as being cheap. The core to Dan’s presentation is to match up cheap options with directional outlooks. A pre-trade volatility analysis is a key to seeing if options are overpriced or underpriced. An implied volatility edge can become a profit in two different ways, either if the direction of the trade works to the option’s benefit or if there is an increase in implied volatility that offsets time decay.
He then goes on to demonstrate a trade that makes sense when there’s a “Negative Volatility Edge” or when volatility is overpriced. He shows an example of having a bullish outlook for the Energy Select Sector SPDR ETF (XLE), but at a time when the implied volatility is elevated relative to the historical range. He points out a call he finds somewhat attractive, but then also shows another higher strike call that he sells to offset the cost of that long call.
The presentation finished up discussing trading management. Dan notes that good trade management starts with good trade construction. Two types of covered calls are contrasted as examples of types of trade management. A passive covered call requires no management if the desire is to all shares to be called away. However, you may trade an in the money or out of the money call option as part of a covered call strategy. An in the money call is part hedge, part exit strategy as the stock price is above the strike price and there is a higher likelihood that the shares may be called away. An out of the money call being sold reduces the likelihood that shares will be called away since the stock needs to rise in price for that outcome to occur.