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Owning Options Makes Sense at High Stock Prices and Low Volatilities

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We’re deep into earnings season and the major averages are all at or near all-time highs. Lately, there have been a few big moves (in both directions) but the trend has been a steady march higher for the broad markets. Consequently, option implied volatilities are at the lowest level they’ve been in over a year.


Let’s say you think that trend will probably continue through the rest of the quarter – a steady move higher, but you also believe there is a high probability of some sharp moves along the way.


The right strategy to earn additional returns in the options markets during periods of both low vols and the potential for big moves is to own “gamma.” You might recall from previous discussions about options greeks that delta is the price sensitivity of an option to a move in the underlying and that gamma is the delta sensitivity of an option to a move in the underlying – how much the delta changes when the stock goes up or down.


If you own an option, you are long gamma. If you purchase a 50 delta call, it will behave as if you own 50 shares of the underlying stock. If the stock rises, the delta of that call increases, making you synthetically longer the underlying. If the stock declines, the delta of the option decreases, making you synthetically less long the underlying. Just like calls, owning puts also makes you long gamma - though obviously the delta works in the opposite direction.


Having a position that increases or decreases exposure to the underlying in the direction that the stock is moving is obviously advantageous, but it comes at a price – time decay. If you own options and the underlying is not moving, they lose a portion of their value as time passes. That time “decay” accelerates as expiration approaches and an option that’s about to expire out-of-money becomes worthless.


In periods like these when the market is not showing a clear directional trend and the effect of news stories and other events cause large moves, owning gamma can be profitable.


The Strangle


If you were to purchase a 2% strangle on (SPY - Free Report) (the S&P 500 Index tracking ETF) – buying one call and one put that are both currently about 2% out of the money – you’d be long gamma. When the index rises, the delta of the call rises and the delta of the put falls, making your exposure to the market more like a long position.


When the index falls, the opposite happens and you are shorter the market.


In the options that expire on June 18th, the total cost of buying the 407 strike put and the 427 strike call would be approximately $11. That’s the most you stand to lose on the trade if both options expire worthless.


A conventional options p/l diagram for the trade would look like this:


It shows that you stand to make unlimited profits in either direction if the SPY moves significantly and profits on the trade start if SPY moves outside the strikes by more than $11/share, but that’s only if you hold the trade to expiration.


If the market moves up and down frequently between now and expiration, you can still make money on the trade even if it doesn’t finish below $407 or above $427.


If you wake up one morning and a particularly positive or negative development has occurred that’s causing the market to rise or fall quickly, one of your options will appreciate much more quickly than the other depreciates because of the effect of gamma.


Let’s look at a big down move.


If the S&P 500 opened down 2% tomorrow - about $407/share at the time of this writing, the 407 put would be likely be worth somewhere around $10 or $11. You’d have a few choices. You could hold the trade to see if it continues to go your way, or sell the put for a profit and continue to hold the 427 call which will appreciate if the market rallies.


Or you could buy stock at $407/share. You now have only upside potential and no downside risk on the trade.


If the SPY were to subsequently rally back to $417/share by expiration, you’d sell the 100 shares you bought at an $10 profit, the options would expire worthless and you’d have a small loss of $100 on the entire trade.


If however SPY rallied all the way to $435/share, you’d have 200 shares to sell (the 100 you bought, plus 100 more from the 427 call) and a net profit of $2,500. ($3,600 in stock trading profit minus the $1,100 you initially paid in premiums.)


Basically, owing the strangle (and the gamma) allows you to buy shares on declines and sell them on rallies while still knowing what your absolute worst-case scenario risk is.

When implied volatilities are low, options have more gamma and less time decay. That's when you'd prefer strategies in which you own them.


-Dave


David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.
 

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.


 


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