Two tried and true ways to tame market uncertainty and make volatility work in your favor.
The title for this week’s article comes from one of my favorite songs from one of my favorite bands- The Clash. No doubt that the Bulls and Bears have been clashing since the beginning of the year.
Volatility certainly has returned in a big way to the markets. The Fed hiking rates and the ongoing geopolitical turmoil out of Ukraine adds to the uncertainty. Although the VIX has softened recently, it remains at elevated levels. The Average True Range (ATR) in the SPY, a measure of actual volatility, reached the highest levels since the Covid Crisis.
The recent quote below from our Stock News CEO Steve Reitmeister sums it up:
If you enjoy the volatile nature of the current stock market (SPY), then I recommend you get your head examined. For the other 99.9% of you, these are unsettling times and it requires a clear outlook and disciplined approach to navigating these choppy waters.
I wholeheartedly agree with Steve about having a clear outlook and disciplined approach in any market environment- but especially now.
Maybe it’s my option trader nature to embrace the suck, to borrow that military term. But call me crazy and count me in the 0.1% who enjoy the current volatility. To me, volatility begets opportunity.
The opening line from If- by Rudyard Kipling exemplifies this notion:
If you can keep your head when all about you are losing theirs
Somehow, I have now tied Steve to Rudyard Kipling. Now let’s tie a couple simple and straight-forward option trading strategies to these volatile markets. It is a way to position to profit from uncertainty and better embrace the suck. All while reducing your overall risk.
Option prices are still high. This means favoring option selling strategies when structuring trades. Both of these approaches incorporate selling to take advantage of the historically rich option premiums.
Selling Covered Calls
A covered call is the combination of a long stock postion and a short call position-hence the covered term. It involves buying 100 shares of stock and selling 1 call option for every 100 shares of stock purchased. Most traders tend to sell slightly out-of-the money covered calls to still allow some upside appreciation in the stock.
For example, Apple (AAPL) stock closed at $163.98 on Friday. The June $170 calls closed at $6.30. Buying 100 shares of AAPL stock and selling 1 of the June $170 calls would cost $157.68. This reduces the cost of the AAPL stock purchase by nearly 4%. It does, however, limit gains if AAPL stock gets to above $170-or 3.67% higher.
In essence, you give up some of the upside to protect some of the downside. The upside is greater and the downside is less since option prices are compartaively more expensive now. You can also sell calls against existing long stock positions to hedge some of the downside in a similar manner.
Buying puts gives the buyer the right to sell stock at the strike price. Selling puts obligates the seller to be a buyer of the stock at the strike price. Most traders sell slightly out-of-the money puts to allow for some downside cushion.
Let’s look at selling Microsoft (MSFT) puts. Microsoft closed at $300.43 Friday. The June $285 puts ($15.43 out-of-the-money) closed at roughly $10.50. Selling the June $285 put would bring in $1,050 in option premium ($10.50 x 100). It would also obligate the seller of the put to be a buyer of MSFT stock at $285 if Microsoft was below $285 at June 17 expiration.
Break-even on the trade is the strike price of $285 less the option premium received of $10.50. This equates to $274.50 or 8.3% lower than the current price of MSFT stock.
You get paid up front now to be a buyer of Microsoft later at lower levels. Higher option prices means the amount you get paid upfront is larger and the price you may ultimately buy at is lower. Important to sell puts equal to the number of shares you are willing to buy.
Selling puts is a way to be a buyer on a dip. Selling covered calls pre-positions you to be a seller on a rally. Combining the two strategies allows you to both stay and go at pre-determined levels.
Vital to remember that the other song on the double-sided A single along with “Should I Stay Or Should I Go” was “Straight To Hell”. In this market environment, it is wise to remain fearless but never reckless. Take advantage of the opportunities from volatility in a decisive but disciplined manner with some covered calls or put sales.
What To Do Next?
If you’re looking for the best options trades for today’s market, you should check out our latest presentation How to Trade Options with the POWR Ratings. Here we show you how to consistently find the top options trades, while minimizing risk.
If that appeals to you, and you want to learn more about this powerful new options strategy, then click below to get access to this timely investment presentation now:
All the Best!
SPY shares closed at $444.52 on Friday, up $3.45 (+0.78%). Year-to-date, SPY has declined -6.41%, versus a % rise in the benchmark S&P 500 index during the same period.
About the Author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as a Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His overriding passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the Power Options newsletter. Learn more about Tim’s background, along with links to his most recent articles.