Volatility Isn't Always An Option Trader's Friend

 
How Volatility Can Hurt

But it Can Also Help

An Example of a Recent Option
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If you listen to investment analysts and pay attention to the financial news networks, you will often hear phrases like “it’s a traders market” or “option traders love volatility.” This isn’t necessarily the case.

If you look at the market from June 6 through 14, you see an up day followed by a down day, followed by an up day. This is the epitome of volatility, but the market didn’t go anywhere. Just look at the chart of the Nasdaq below and you see how there was little change in the value from the close on June 6 through the close on June 14, but the movements in between these two closing prices were all over the board.

Chart 6-18-12

 
As a buyer of options, such volatility is of little use unless you are daytrading. If you are trying to take advantage of a trend by buying a put or a call, this type of market does more harm than good. Because options have an expiration day, each date that goes by causes an option to lose a little time value.

Investment people express this time decay using the Greek letter theta. The theta measures how much an option will decline in value each day if all other inputs remain constant. A theta reading of -0.05 means that the option will decline in value by five cents each day even if there is no change in the underlying stock.

Let’s look at an option on the PowerShares QQQ Trust (QQQ), an ETF that mimics the movement of the Nasdaq 100. On Thursday, the QQQ closed at 62.36 and on June 6 the ETF closed at 62.54, meaning after six trading days, the QQQ lost 0.18.

Looking at the July 62 strike call on the QQQ, we see the price at the close on Thursday was $1.97. On June 6, this same option was trading at $2.25. In other words, the ETF declined $0.18 while the option declined by $0.28 during the same period. That 10-cent difference can be attributed to time decay. The theta as of Thursday on the July 62 Call is -0.03, meaning that if the price of the QQQ doesn’t change over the next five days, the option will decline by $0.15.

In other words, if the market were to repeat the pattern over the next six trading sessions that it went through from June 7 through June 14, the July 62 Call on the QQQ would decline by almost 10% while the underlying ETF would hardly change at all.

During the period from June 7 through June 14, the option traded as high as $2.46 and as low as $1.66. So you would have had to time your entry and your exit almost perfectly down to a 30-minute window to make a decent return. This is not the kind of volatility most option traders are looking for and it is certainly not what I look for in my Cabot Options Trader recommendations.

To further explain volatility, a 50 stock that goes up by 0.25 every day would have an implied volatility of zero, yet it would be gaining 0.5% every day. Over a 10-day period, the stock would gain 5%. I would much rather buy calls on a stock like this than buy calls on the QQQ during a period like we saw from June 7 through June 14.

Volatility isn’t necessarily an option trader’s friend.

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But volatility is not always the enemy either.

Here’s an example of volatility helping us on an option that I recently closed.

We bought the June 56 Put on the SPDR S&P Oil and Gas Exploration and Production Fund (XOP) on May 3 after receiving numerous bearish signals on oil and gas exploration stocks and a bearish signal on the ETF itself. Our average price for the option was 3.17.

The ETF continued to fall and we closed the first half at 4.53 on May 7 for a 43% return. We kept the second half of the option open, watching the 10-day moving average as a possible indication to close out. On May 15, we closed the second half of the option at 6.55 when the ETF reached oversold territory, for a gain of 110%. Combined with the first half, the overall return for the option was 75%.

Your guide to options trading,

Rick Pendergraft
Editor of Cabot Options Trader

Editor's Note: This investing strategy can net you gains of 67% or more in a mere 20 days, with an upfront investment of $500 or less! The best part? This strategy works in both up and down markets, allowing you to make HUGE gains without buying stock in a single company. Click here to learn more.

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