Choose an Option Strategy Based on Actual vs. Implied Volatility

It is important to differentiate between the implied volatility of option prices and the actual volatility of the underlying stock or ETF.  It is not an easy task to recognize when the two measures deviate from one another, but if you can identify a difference, huge gains can be made with the proper option strategy.

Today we will discuss how you can capitalize on any differences that you might be able to find.

Choose an Option Strategy Based on Actual vs. Implied Volatility: 

 
Last week the European debt crisis was apparently averted, at least in the eyes of option investors.  VIX, the so-called “fear index”, the average implied volatility of option prices on the S&P 500 tracking stock (SPY) fell dramatically to just below 25 (still above its mean average of about 20 but well below the 40+ it has sometimes been at during the previous month).

When option prices are high (i.e., implied volatility, VIX) is high, there are huge gains possible by writing call options (not our favorite ploy) or buying calendar spreads (our favorite most of the time).  However, when actual market volatility is greater than the expected volatility (i.e., implied volatility of the option prices), writing calls or buying calendar spreads is generally unprofitable.

Over the last three months, we have had great difficulty making gains with our calendar spreads because actual market volatility was too great.  On the other hand, we have had some luck with buying straddles (or strangles), a strategy of buying both a put and a call on the same underlying and hoping that there is a big fluctuation in either direction.

Last Wednesday, after following VXX (a “stock” that is based on the futures of VIX), we noticed that actual volatility was huge – it had fluctuated $2 or more almost every single day for several weeks.  On Wednesday in one of our portfolios we made a small ($1400) buy of 5 VXX 43 puts and calls which would expire two days later.  We paid $279 per straddle.  When the market for VXX opened up sharply lower on Thursday, we sold the straddle for $596, netting 117% after commissions.

In another portfolio where we owned calendar spreads on VXX, we lost money.  Our results in these two portfolios clearly demonstrated that when high actual volatility occurs, you do best by buying short-term options, either puts or calls depending on which way you believe the market is headed, or both puts and calls if you admit you really don’t know which way it will go (as we usually do).  On the other hand, when actual volatility is low, calendar spreads deliver higher returns.
Now that much of the uncertainty facing the market has subsided a bit, we believe it is time for the calendar spreads to prosper once again as they have for most of the past few years (since late 2008 extending up to August of this year).