The two most common questions I receive as a mentor to options traders -
What is volatility?
Is implied volatility significant to my options trading?
My answer to these options trading questions is clear, “Volatility is the most fundamental component in options trading to understand.”
What Is Volatility?
Implied volatility is a measure of an option to rise and fall within a given period — implied volatility trades on supply and demand. The more uncertainty and worry in the financial market, the higher its implied volatility will go.
When you are trading options, volatility is one of the most important things you must understand and utilize.
Is Implied Volatility High?
One of the easiest ways to track the implied volatility in the market is monitoring CBOE VIX futures. VIX futures are standard futures contracts on forward 30-day implied volatilities of the S&P 500 index. VIX futures are very liquid, and trade bid/ask spreads are narrow.
Other alternatives to VIX futures are the ETFs UVXY and VXX and the implied volatility on the actual S&P 500 options.
Implied volatility has a mean-reverting pattern, meaning there are periods when it deviates from the historical average and then reverts to the norm.
The key is recognizing when implied volatility is at an extreme level relative to its historical average, then structuring a trade accordingly.
The Trading Signal
Pinpointing volatility expectations and timing is pivotal to your trading success with options.
We like to use the ratio of CBOE VIX futures to historical volatility in the S&P 500 to determine the volatility portion of the trading signal.
This ratio helps us determine if volatility is high or low on a relative basis. We tend to prefer short volatility options strategies when the ratio is high, and long volatility trade structures when the ratio is low.
You can use many other combinations but be consistent with the ratio used.
How Do Traders Take Advantage of High Implied Volatility?
My favorite options strategy, when implied volatility is high, is using S&P 500 long butterfly options spreads.
Example of Short Volatility Long Option Butterfly Spread
There are many ways to configure a long butterfly options spread. The standard way to structure a long butterfly options trade is to sell two options at-the-money (ATM) and buy one long that is 50 points up from the center and one long that is 50 points down from the center.
All options contracts have the same calendar expiration.
You can configure the butterfly strategy with put or call options.
For example, if the S&P 500 is trading at 2940:
Sell two 2950 put options, and
Buy one 3000 put option, and
Buy one 2900 put option
What’s Goal of Long Options Butterfly Spread?
The long options butterfly spread profits if S&P 500 price trades in a narrow price range and if implied volatility falls.
The Options Greeks Profile of Long Options Butterfly
The profile of the trading strategy is short Vega (volatility) and positive theta if the S&P 500 index is in a range between the lowest and highest strike prices. If the index moves out of this range, however, the theta becomes negative as expiration approaches.
Trade Setup for Long Butterfly Spread
We prefer expirations in the S&P 500 between 30 to 50 days until option expiration.
The long butterfly spread gives traders the benefits of time decay and a range that the SPX could trade and be profitable, as well as being short volatility.
How to Size Long Butterfly Trade?
The profit payout of a long butterfly spread is high compared to risk capital. Traders typically trade a large number of butterfly spreads if the goal is to earn a profit in dollars equal to other short volatility options strategies like short straddles or strangles.
The benefit of using butterfly options spread is the maximum risk is 100% of the cost of the position.
Long Butterfly Option Strategy Discussion
#1 Making Implied Volatility Forecast
We want to buy long butterfly spread when implied volatility is high and expected to fall. Long butterfly spreads have negative Vega. This means that the price of a long butterfly spread falls when implied volatility rises. When implied volatility falls, the price of a long butterfly spread rises. Long butterfly spreads should be purchased when volatility is high and future volatility is expected to decline.
#2 Price Forecast Before Options Expiration
Butterfly spread structures fit into the class of “non-directional” option strategies. A long butterfly spread does not profit from index price changes; it profits from time decay (Theta), as long as the stock price is between the highest and lowest strikes.
#3 Time or Theta Decay
The butterfly strategy takes advantage of time (Theta) decay.
A long butterfly option spread with puts has a net positive theta if the S&P 500 index is in a range between the lowest and highest strike prices. If the index price moves out of this range, however, the theta becomes negative as expiration approaches.
Look for expirations 30 to 50 days until option expiration.
Long Butterfly Options Spread Maximum Profit
The maximum profit potential is equal to the difference between the lowest and middle strike prices less the initial cost of the position. Maximum profit is realized if the S&P 500 price is equal to the strike price of the short option (center strike) at expiration.
In the example above, the difference between the lowest and middle strike prices is 50, and the net cost of the strategy is 15. Therefore, the maximum profit is 35 (50-15).
Butterfly Options Spread Maximum Risk
The maximum profit potential is equal to the difference between the lowest and middle strike prices less the initial cost of the position.
Example of Other Short Volatility Options Spreads to Consider
There are many options spread strategies you can structure for short volatility. All have different profiles, so DYOR (do your own research). A few option structures worth exploring are iron condors, calendar spreads and straddles and strangles.
Summary of Using Volatility for Long Butterfly Options Strategy
Watching the volatility index to time your trade entry is pivotal to your trading success with options. Often you can have on one long volatility and one short volatility trade to hedge yourself in a turbulent market.
**Just remember, this is a trade idea only and not investment advice. Do your own research and consider your risk tolerance. Know your risk.