Introduction:
The market is riding high, so I wanted to review this trade just in case we get some more volatility next week.
Call spreads are a common options trading strategy and setting up the spread to take advantage of anticipated volatility crush situation is fun and profitable.
Trade setup
There is great fear or economic uncertainty about recent news of Chinese and American Trade Talks.
The VIX is very high.
The VIX is a measure of market volatility.
I pick a stock with a bearish overall chart, but it’s option premiums are higher then usual due high market volatility.
I sell ten contracts of call options one point above the market price
I buy ten contracts of call options five points above the strike price of the options I sold.
Both are 45 days to expiration
I collect 2$ or 200$ per contract
I risk 5$ or $500 minus the credit received $200 or $300.
My goal in all spreads is to collect at least 1/3 of the spread between the strike price of what I bought and what I sold.
On a five point spread that’s $1.65, so I am very happy to collect $2.
In three days, the trade deal with China is announced as a success. The market breaths a sigh of relief and market uncertain is reduced, this reduces market uncertainty and volatility is reduced rapidly. This falling volatility reduces option prices significant. This is known as volatility crush, when a rapid decline in volatility causes a rapid decline in option prices. It is also abbreviated as Vol Crush.
The price of the options falls over 35%
I can now buy back the one I sold for $5 for $3
And sell the one I bought for $3 for $2.75
I make $2 on the ones I sold
I lose 25 cents on the ones I bought
I make a net of $1.75 or $175 per contract on this trade in less then 7 days due to the drop in Volatility dropping the premium so fast.
Summary;
This is called Volatility Crush.
This happens when there are periods of great economic or political uncertainty. Then when the uncertainty resolved the volatility falls. Option premiums follow market uncertainty and volatility.
The important takeaways are;
Political or economic uncertainty combined with high VIX means higher option premiums.
If the political or economic uncertainty resolved quickly
the market volatility falls and previously inflated options premiums drop rapidly and a lot.
This gives sellers of options a window of opportunity to sell high and buy back low.
This is not a high probability trade.
Probably a 51% probability of success.
So I would not normally trade this low probability trade, but because I was anticipating volatility to fall and reduce the option price’s quickly I made the trade.
I kept my percentage of capitol at risk low for this trade for those reasons .
Last words on Fear and Greed
Now I used five point spread. I could have made more money with a 10 point spread, but my risk would also increase from $500 to $1000 minus whatever credit I collected. I could have made more money trading 20 contracts. But that would double my risk. It’s important to trade less then 5% of your portfolio to limit your losses and your fear of losses. Most spreads are losers at some point in their 45 day life, but if you plan your trade and stick to your plan you will win a high percentage of your trades. Trading less then 5% of your capitol gives you more courage to control your fear. When you over allocate capitol to a single trade you are naturally more fearful as the loss is more significant and you will close trades at a loss to soon. Options trading should be high probability trades with never more the 2.5-5.0 percent of your capitol at risk on anyone trade. In options trading the emotions of fear and greed are your biggest enemy. Fear makes you exit trades to early and close for a loss. Greed makes you put on trades to big for your account. The size of the trades increases your fear. In options trading we call this bring greedy.
In American English we call greedy people pigs. In options trading we have a mantra; bulls get rich, bears get rich, but pigs get slaughtered. Don’t be a pig.
✍️ written by Shortsegments
title: Option Trading: Volatility Crush Trade
tags:#bankingandfinance #options-trading #volatility-crush #playoftheday