Want to Be An Options Trader? Part II

Meet Your New Friend: Volatility

Read Part I

Last week I introduced you to two calendar trades to take advantage of low volatility in the options market, which is great for scenarios when the market is calm and slowly chugging along.  Late last week the market got spooked and started swan diving on us, so how do we change our game plan to take advantage of the down move?  Good thing for you, my trade this week is designed exactly for this situation.  But first, let’s learn more about volatility.

What is high volatility?
Remember that last week that we described volatility as the “black box” factor that is derived from an options price.  But what exactly does an increase in volatility mean?  Let’s look at this as if we are an institutional money manager.

Pretend for a moment that you’re a big time portfolio manager for a hedge fund or mutual fund.  You’ve got a high pressure job because you are always worried about one thing—your numbers (the measured return for you fund).  The biggest thing that can go wrong is a crash—either the whole market crashes or one of the companies you’ve invested in crashes—and your numbers will suffer, and more importantly, your bonus will shrink from “second house in the Hamptons” to “first months rent up front in New Jersey.” 

Lucky for you, the market offers a form of insurance you can buy to hedge against a crash, and that insurance comes in the form of put options.  If you own a company’s stock, you can buy put options for the underlying stock to eliminate your risk that the stock price falls below the strike price you select.  If your portfolio is exposed to the entire market falling, you can buy put options as protection against a specific market index falling below a certain level.

One day you drive into work and park in your special “Reserved for Mr. Portfolio Manager” parking space and head into the office.  You fire up the computer, start reading the news for the day, and after ten minutes your heart is racing, and your palms are sweaty.  There is a bevy of news that you think has the potential to tank the market.  You quickly assess how to minimize your fund’s losses and you decide you are going to buy SPX puts when the market opens to keep things from getting ugly (SPX puts are put contracts that settle in cash based on the underlying stock prices in the S&P 500 at expiration).  Notice that YOU DID NOT DECIDE TO SELL ANYTHING in your portfolio, instead you are actually BUYING a derivatives contract as a form of insurance.  The problem is that many of your competitors have the same idea, so now you are all willing to pay more for the same put contracts.

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