How to Trade Volatility with Options – SJ Options

San Jose Options presents learning to trade with volatility instead of against it. Understanding these concepts can greatly improve your option trading. Watch this video to learn the basics of implied volatility, how it reacts to different market conditions, and how to apply the knowledge in the architecture of your option spreads.

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How to Trade Volatility with Options

Video Transcript

Hi there and welcome to this tutorial on trading volatility with Morris. At San Jose Options, one thing that we focus quite a bit on is or vega position in our trades. Obviously we focus on all the Greeks but when the market wakes up and volatility really moves, then, it really comes apparent on how important your vega position really is and it’s also very important to understand how implied volatility reacts across the option chain as well as across the different months and throughout time. When you have a better understanding of the reaction of volatility when the market crashes as it has recently, you can really design better trades and you can design trades before the market crash. You could learn how to design trades for insurance and as well as design trades after a market crash that could take advantage of the volatility skews that happen, again, across a single-month’s option chain or across the different months. That’s what I want to talk about a little bit here.

What we’re looking at is the chart on the RVX which tracks the Russell and I just highlighted some of the peaks. Now, when volatility reaches these peaks, then, it’s important to have very clear what is happening across the option chain as well as the different months. Let’s come over to the volatility charts and take a look. What we’re looking at here is the Russell and we see the volatility graphs of puts across different months. You could see the months in here. You’ll notice that the highest ones, let’s take off, I don’t know if you could see that. Can you see that okay? It’s a little bit dark. But you’ll notice the short term months are the ones that are higher.

Look for example, these three. The ones that are farther out in time, you’ll find them at the bottom. The first thing that we noticed is farther in time, the volatility is flatter and lower. However, we notice here closer to the money, they all intertwine and they’re all pretty close together. Once again, farther out of the money, you have a flatter graph farther out in time. Shorter term, it really spikes up and this was much more pronounced a few weeks ago. Lately, the market’s been coming down a little bit but when we were going through the market turmoil, this part over here that’s kind of like a fan, it was even fanned wider apart and the skews were greater and the short term months were going even more vertical almost straight up and down. They start to form almost just a really defined U-shape. Where again you’re farther out in month, implied volatility across that chain is just always smoother.

There’s certain things that we can learn from this study. I mean, it has to do with designing trades before a crash or designing trades when market volatility is low and also designing trades when after a crash when volatility is much higher. I mean, it’s pretty logical but with options, you know, the goals, when we set up trades we like to try to sell high and buy low. Just looking at this graph, knowing that we just went through a market crash, we now know that the shorter term out of the money contracts are really inflated. Then we also know that these contracts here, they’re not so skewed or inflated. Again, notice there’s not much difference here between the different months. However, over here, there’s a dramatic difference between all the months.

One thing that we can clearly see and imagine in possible trade step would be, like, if you know, when you think of it, a time spread or a calendar spread over here for example, you’ll be selling high and then buying something over here that just doesn’t move as much and it hasn’t moved as much over this crash. Another architecture trade you might consider, again, it’s telling something, over here, high and buying something even closer over here that perhaps haven’t moved as much either. Those are some concepts.

Now, let’s go back before the market crash. When volatility is low, then, imagine if you were to sell your contracts over here. Let’s imagine you were doing iron condors before the crash and, again, you were selling your iron condor out of the money like this. If you had started some iron condors before the crash and then the market volatility went up immensely like it did, your trades over here would be demolished because you, again, you sold when that volatility was really low. The vols went up so your iron condors just got demolished. Same thing with, like, a credit spread if you were out of the money.

Imagine if you were doing a condor closer to the money, more on this range, if you had done the trade in here, volatility went up a little bit. You know, it might have went up 5-10 points but notice over here, it could’ve gone up maybe 50 points or 60 points or 100 points, that’s just the big difference. You see the difference there? The other thing to consider is look how vertical this minus here. Let’s say, before the crash, if you were doing a condor and you were using spreads that were like, let’s say, something exaggerated between all the way 200 to like 400.

Again, let’s say you were to sell this strike here, the 400, and you had bought one over here. If that was the case you could just see there’s a huge difference here between those strikes. If you had purchased the one way over here and then the vols went up like they did, now you could see how that could be advantageous to where if you had done a 200 to 250, if you did this 50-point spread here. Because in this case, if your short strike was right here, then it would’ve gone up quite a bit almost as much as like this one did. But if you had, in this case, if you had the spread really wide apart, then maybe the short one over here, perhaps it only went up a little bit and the one you have far out of the money might have went up a lot more.

Actually, if you have this really wide spread, credit spread or a wide condor on before the crash, then it might have been safer than if you had used like a 10-point wide iron condor, for example, on the Russell because then your short strike just would’ve been so far out of the money as well. That trade there didn’t have that differential to where the long strike had sort of an advantage. It’s really interesting when you think about how the smile changes when we have a crash. The main thing is we need to understand that out here, out of the money, this fan gets wider and wider apart between all the different months. So, you start to develop a lot of skews and also the shorter term months develop this graph that’s almost vertical like this. If you have your strikes close together, then you have one situation where the short and long, they both go up a lot. If you happen to have a long right here and a short, for example, way over here close to the money, well then maybe your short won’t go up much but the long will go up tremendously. That kind of trade could actually be a lot safer to do when you have a low volatility market.

Now, back to the current market where the vols have already risen. Again, what if you sold over here and bought something over here that hasn’t risen as much, then, if the market comes back the other way, let’s say volatility drops back down. Now, again, you have the differential between, what I mean by differential is just the space, the width in the spread here, so your 200’s will collapse quite a bit. However, if you had something at the money, like 700-750, then these won’t collapse much. Your long contracts will hold that value while the short ones really collapse.

Hopefully, that makes some sense to you and you could put that knowledge to use whether you’re doing, trying to construct condors or credit spreads or butterflies or calendar spread, diagonals, whatever trade you’re doing. If you just understand these basics about volatility and how the implied volatility changes throughout time as well as on each particular month, then it can really help you make adjustments, help you set up your trades in a better way, in an advantageous way. When the skews correct the other direction, you have your strikes properly placed. Hopefully that makes sense.

Let me see if I could bring in the pencil and just clear it up a little bit more. Let’s say, current market. Let’s just say current market and implied volatility went up quite a bit. Now, these strikes over here, they’re really inflated so I’ll just say the IV is high. It really behooves you to sell over here but only if this market’s ready to settle down. If you think the market is going to continue to crash, then, you know, it’s not going to help so much to sell over here now. However, now that the vols have already risen, there’s a lot less risk than before but before selling over here, it always makes sense to wait a while after a crash and to continue studying the charts.

I like to look at the Macd divergence and see if see Macd divergence happening. That really gives me a good sign for market reversal. But let’s say implied volatility is risen and you feel like it’s going to come back down or at least settle. So we sell over here and then, again, you can buy over here where the volatility never went up quite as much. It’s kind of like lower IV. It’s just in an IV that’s not quite as inflated. Obviously, the whole option chain is going to be inflated right now but these are inflated more and you could just see it by the span here between all the different months. You could see how it gets more inflated.

Now, the next dimension to add to this is shorter term and we’ll say something like less than 60 days, for example. You have something a little bit closer in and you could just see the months here, how much they’re inflated. And then, again, farther out here. Again, buying and we’re just exaggerating things but what if you went all the way to like December 13? In this case, you’re looking at contracts that were inflated the least over those market crash, getting a pretty decent price for those. And then you’re selling something up closer, you know, 60 days or 30 days out, something that’s really inflated. That would be taking advantage of the market that’s already crashed and so on. Before the market crashed, basically you’ll do something that’s opposite.

Let’s say, market volatility was really low and you wanted to prepare and construct and insurance type of trade. Well, then over here where you’re selling now, basically, you have been buying out of the money’s when IV was really low and then you would be selling something that’s closer to the money. And then, you could even be doing the same month or you could be doing just the complete opposite. Farther out in time, our studies show these don’t get affected as much. What if you were to sell something out here, well, when we go through this market crash, those ones they really don’t go up much but the short term out of the money long puts, they could go up dramatically. It could be a really nice design for some extra insurance.

Now, when you think about this, remember don’t limit yourself just to this kind of design. Think about this with all your trades, think about this with your credit spreads with your calendar spreads, with your diagonals and just every kind of trade you do, go through these steps. Analyze volatility, where is the implied volatility right now? Where is it headed and then think about your strike placement across different months as well as, you know, on that same month as well as, like, out of the money, in the money, on the money, at the money and things like that and then go from there. That’s really how you can learn to trade better with volatility.
Hope you like that tutorial and thank you very much for watching!