Volatility is a double-edged sword for option traders.
On the one hand, option traders crave volatility because it is a measure of the degree to which stock and ETF prices move. And traders use options to leverage those moves into outsized returns.
On the other hand, higher volatility means that options cost more to purchase because implied volatility (IV) is one of the main factors that influence an option’s price.
Here are a few key facts about implied volatility:
- IV is the market’s estimation of how much a security’s price will move.
- High IV results in higher option prices while low IV results in lower option prices.
- IV usually falls when the market is bullish/flat and rises when the market is bearish.
Like stock traders, option buyers want to buy low and sell high. So, low volatility is good because it means options are cheaper to buy. But high volatility increases the odds of a larger move in the underlying security, which can result in bigger profits.
Let’s take a look at what the current volatility picture looks like.
The chart below shows year-to-date IV for the SPY, the ETF that tracks the S&P 500 and my trading vehicle of choice.
You can see that 30-day implied volatility is below 12%, while historical volatility (below) is around 15%.
So, you could make the case that options are relatively cheap right now since implied volatility is below historical volatility.
That said, it’s only a matter of time before volatility spikes again. Of course, it’s impossible to know why the next big sell-off will occur (another attack in the Middle East, escalating trade war rhetoric, declining global growth, etc.)… or when it will.
But what I do know is that traders who are prepared for this eventuality will be the ones best positioned to profit from it.
3 Tips For Trading A Volatile Market
Being successful in a volatile market requires some adjustments to your trading, and I have a few tips for you.
Tip #1: Don’t hold positions overnight.
I often say that this is a day trader’s market. What I mean by that is there is a real danger in holding positions overnight or through the weekend, especially in a market as news-driven as this one.
The potential for major news — scheduled or otherwise — to move markets is why I tend to stay all cash overnight and through the weekend. There’s nothing worse than holding a great looking swing trade through the night or weekend only to see the position turn dramatically against you before the market opens again. I also remain all cash through major events such as Fed announcements.
So, when do I trade?
Well, the morning… mornings are the best time to trade, particularly the first hour of trading.
Volume and volatility are typically much higher first thing in the morning than at any other time of the day. This is because the market is factoring in any relevant news (economic data, earnings releases, tariff headlines, etc.) that has occurred since the previous day’s closing bell.
Since the first hour of trading generally sees the largest moves in the shortest amount of time, it offers the greatest profit opportunities for traders — especially options traders who can take advantage of the incredible leverage options provide.
I see proof of this day in and day out with my Trade Of The Day, which I deliver to members’ email inboxes 30 minutes prior to the market open each day.
The Trade Of The Day represents the single option trade for traders on a given day. The goal is to get in and get out quickly, usually within a few minutes to a few hours after making the trade. This way we avoid the risk of holding positions overnight.
Tip # 2: Go for base hits rather than getting greedy.
This is something I advocate all the time to Trade Of The Day members, but it’s especially important when volatility picks up.
Many people hold on to positions too long only to see gains evaporate, and positions can turn against you much faster in a volatile market than in a calm one.
So, I urge traders to aim for quick base hits rather than home runs. And the best way to do this is by using support and resistance levels to guide your entries and exits.
For instance, when a stock finds support at a certain level, it signals a demand for shares at that price point. So, support areas often make for good entry points for call options.
Resistance areas, on the other hand, are price points where the stock has stalled and the bears have been able to push shares back down. So these levels are often ideal spots to take profits.
Of course, if you are buying put options, this is reversed. Resistance areas are often good entry points and support levels are where you should look to take profits off the table.
Tip #3: Don’t panic.
When the next big market drop comes, it’s important that you remain calm. Sell-offs are a part of investing and allow the market to take a necessary breather.
I, for one, am looking forward to the next drop. I know that might sound crazy but it’s true. And that’s because options traders can actually make a lot more money on red days… if you have the right system.
For instance, two of the worst days for stocks so far this year took place last month.
On Aug. 5, the S&P 500 plummeted 3% on escalating trade tensions as President Trump accused China of currency manipulation.
And, on Aug. 14, the index sold off 2.9% as an inverted yield curve flashed a recession warning.
But traders who stayed calm and followed my Trade Of The Day alert could have made as much as 158% on Aug. 5 and 101% on Aug. 14.
If you recall, August was a rocky month for investors. But Trade Of The Day members had the chance to make some serious profits on 19 out of the month’s 21 trading days. And more than half of those profitable opportunities were bearish bets on the market.
This kind of consistency goes a long way in helping traders remain calm when volatility hits. So, I urge you to take a little time to learn my system before the next big market drop.