How to Take Advantage of Volatility
We all know options can make profit when the price of the underlying stock or ETF rises, declines, or goes sideways. However, on top of this, they can also make you money if the implied volatility of the underlying asset rises or declines.
Here are 2 trades you can use to take advantage of this and precisely when to use them.
Rising Volatility
Rising volatility causes the prices of options to rise. This is measured by Vega which tells you for every uptick in Implied Volatility or IV, how much with the price of the option will rise.
My favorite trade to take advantage of this is the Double Diagonal trade. While it is a bit of a mind bend to understand how these trades work this is how I find them and carry them out.
First, scan for stocks that have LOW volatility relative to their historical average. Anything below 20% is a candidate. If you can find a stock at 10% or below, those are gold.
Next, those stocks that are at 20% or less, find those that have an upcoming Earnings Report.
Now you have your candidate trade. Sell the short strangle portion closest to, but after the earnings report. Next, buy the long strangle portion of the double diagonal a month later.
The expectation is that when earnings are reported, the IV will spike close to 50% to 100% of the historical average and while the value of the short strangle will rise quickly, the time decay will have already eaten away at the option. The time value and Vega value of the longer dated options will rise just as fast and allow you to book this trade for profit. Here is an example of a low IV position currently for MARA. They are expected to report earnings on May 8. So, we will use the May 10 expiry for our short strangle and June 21 for our long strangle to build the combined double diagonal position.
Now look what happens if IV spikes around earnings and look how
the profit profile changes:
It gives us a great exit for profit.
One of the best ways to take advantage of a decline in IV is to use the Iron Condor strategy. It is simple to execute and understand.
Declining Volatility
To find great candidates for this trade, do the reverse that we just did for Double Diagonals, look for those stocks with high IV relative to their historical 1-year average.
Ideally, look for those stocks that just reported earnings and the IV spiked but should return to normal levels soon. This will allow you sell the short options wider relative to what would normally be required.
Once the stock settles down, hopefully within the range of your short options, then IV should decline allowing you to take your profits.
It is not absolutely required to find those stocks that just reported earnings, but you do want to find those that have high relative IV compared to their historical 1 year average.
Here is an example using GOOGL which at the time of writing this, it is at 99% IV relative to the 1 year historical average and the 1 year High is 37.01% so it is extremely out of bounds right now and should settle down soon.
This allows us to sell a wide Iron Condor and still collect good profits.
See how broadly we can place the strikes? See how wide the bell curve is on this trade? Profitability is at 65%
Now watch what happens when we “crush” IV back to normal levels.
See how the bell curve tightens and the probability of profit skyrockets? As certainty returns to the stock, the volatility will decline.
These are 2 easy ways to execute Vega or IV sensitive trades and make money.
We trade both strategies at CFU and get our members fantastic results.
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Looking forward to trading with you!
Stephen
President, CFU
