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A Guide to Volatility Option Strategies

Investing money in the stock market when things are volatile or uncertain can be even riskier than during normal periods of up and down movement. However, with the right strategy and knowledge, one can learn to use a volatile market to their advantage. Traders use several indicators to help them determine whether the market will have upward or downward movement, and volatility is the only indicator that doesn’t have a set value to go along with it. This makes it a difficult piece of the puzzle to predict.

Use this guide to learn more about volatility option strategies. This is just one investing strategy, and anyone considering putting money in the market should consult a financial advisor before making any major decisions where their money is concerned. Before investing, understand that there are a variety of strategies out there, and there’s no one-size-fits-all method. However, when market volatility is imminent, having some knowledge about volatile option strategies can help maximize gains during market uncertainty.

Key takeaways:

  • Understanding how volatility option strategies work and how to apply them to grow an investment account is key for making the most of the market during uncertain times.
  • Knowing some of the various option strategies for volatility can provide the necessary tools needed to earn more, even if the market takes a dip.
  • Making the most of market volatility helps many investors maximize their leverage while limiting losses.

What Are Volatility Option Strategies?

Volatility option strategies are ones that help investors make big gains while also mitigating losses. To understand volatility option strategies, it’s necessary to first discuss some of the terms associated with this type of trading method. Where the market is concerned, options are the derivative of an underlying asset that the owner has the right to sell and others have the right to buy. Of course, there’s a lot more to it than that, but let’s move on to volatility.

If someone says that the market is volatile right now or that a certain stock is highly volatile, what they mean is that they’re uncertain as to whether it’s likely to go up or down.

Other important terms to understand are in the money (ITM), at the money (ATM), and out of the money (OTM). When an option is ITM, it simply means it has intrinsic value. On the other hand, ATM means that the strike price is equal to the price of the underlying asset. If an option is OTM, it means that it only has extrinsic value. The strike price is a predetermined price that has to be paid for an option; if it falls below that price on or before the expiration date and the owner chooses to sell, it’s the price the option writer will pay.

The price of an option is determined by several factors. In addition to volatility, the following indicators help determine the price of an option:

  • Price of the asset.
  • Strike price.
  • Type of option.
  • Expiration date of the option.
  • Interest rate associated with the option.
  • Dividend payouts, if any.

Each of these factors, unlike volatility, has a known value associated with it, which is why options can be so risky when the market is volatile. Two types of volatility tracking are out there. The first is historical volatility, which tracks the market’s past volatility in order to help with predicting what could happen in the future. Implied volatility, however, looks at the current price of an asset and current market trends and tries to look to the future to determine where an asset’s price will end up.

Using this data, options traders will write call options if they sense that implied volatility is high, while if implied volatility is low, they’ll short or buy put options. A variety of different options strategies for volatility are used depending on the risk versus reward being projected. We’re going to take a look at some of these strategies to get a better understanding of how some options traders are making money when the market is volatile and minimizing losses if they’re not quite on target with their predictions.

Types of Volatility Option Strategies

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No matter whether a trader is bearish or bullish on an asset, if the market turns volatile, the investor will do what’s necessary to protect their investment. This is when knowing volatility option strategies comes into play. Using one or all of the various strategies can help to ensure maximum gains and minimal losses when applied correctly. Below is a breakdown of what the main types of volatility options strategies are and examples to demonstrate how this type of tactic can potentially benefit an investment portfolio.

Short Put

A short put is for those who are bullish on an asset — in other words, those who think the market is trending upward. When this situation occurs, investors will look for options that are OTM with a high probability of expiring worthless.

Profitability for this type of strategy happens when the underlying asset rises or stays the same. As long as the value of the underlying asset doesn’t drop below the break-even point, which is the strike price minus the premium, a short put can be profitable in a volatile market.

As an example, let’s say someone owns an asset that they paid $50 a share for, and they think that it’s likely to go up to $55 a share. In this case, they’ll want to be in a position to sell a short put option with a strike price of $55. They’d be looking for one with an expiration date within the timeframe they predict the stock would go up. We’ll say three months. Also, the price of the premium is important. For this example, we’ll say it’s $1. Options are for 100 shares; therefore, the premium for this option would be $100.

So, if they’re right and the market moves up, the $5 they predicted either on or before the three-month expiration date, they can sell the put option back to the writer for the $55 strike price minus the premium and any other associated fees. This example would net them a profit; however, the risk for this type of investment is very high and losses are potentially large.

Short Call

While with short puts, investors want a bullish market trend, short calls are for those who are bearish on an asset or think things are trending downward. This means selling OTM options, which earn the most when the price of the underlying asset goes down or stays the same. In fact, the further OTM the option is, the more likely it is to be profitable. Of course, these profits will be lower, which is something to keep in mind.

When it comes to call options, investors look at similar indicators as with put options, such as the strike price, the expiration date, and the premium price. As the option writer, selling a short call means being responsible for buying the underlying asset back at the strike price if it goes above the strike price and the holder decides to sell. However, if the option is held until it expires and it expires worthless, the writer is able to keep any premiums paid for that option.

Short Straddle

Short straddle is a volatility option strategy that option traders use to spread out their risk. When they buy or sell an option with the same strike price for both the put and the call, they’re hoping to maintain the premiums for both the short put and the short call. When using this strategy, traders are counting on the underlying to stay close to the strike price.

Short Strangle

With a short strangle, investors try to minimize their risk by spreading their money between both put options and call options. Investors will sell a call and a put option on the same underlying asset with the same date of expiration. The difference between the put and the call will be the strike price. By having both the put option and the call option with different strike prices, they’re able to allow the asset more room to move around while still being able to realize the largest benefit.

Taking Advantage of Market Volatility

Although lots of traders out there are making money regardless of whether the market is up or down, understanding the complex strategies behind how this is done can be challenging. Investing in the market when things are volatile can be risky, and just like all investing, money can be lost no matter how the market has done in the past. That being said, understanding how options work and the potential for using this strategy for positive portfolio growth has given investors the ability to use market volatility to their advantage.

Learning more about options trading and how to benefit not just when the market is trending up, but also when the market takes a dip downward takes the right educational materials.