Whenever we come upon a holiday, it's time to take a breath and step back. But as option traders, we don't really have such a break; we have to be mindful of volatility and the option decay that constantly exist in these derivatives.
Time is a critical component of option value, and when there are fewer days to trade an option, the decay becomes a detriment to the option buyer. In a couple of weeks, the markets will be closed for a full session (Memorial Day, on May 29). Hence, over the next 10 trading sessions there will be less trading hours availability. Options are not eligible for trading in the pre-market or after hours.
As you might expect, the option seller has an advantage in this case. Selling premium is a great strategy, and certainly much easier when volatility is at extremes. The volatility indicators we follow regularly are the VIX (S&P 500), RVX (Russell 2000) and VXN (Nasdaq).
When these measures are trending they really move, and markets generally move opposite. When the VIX is surging, market players are buying protection and we often see the S&P 500 down sharply. The same goes for the other volatility measures.
Yet, we have seen of late these volatility indicators moving very little, or just staying low. Some articles were out over the past week or so, touching upon the historical significance of a low VIX reading, such as we had this past week with a dip under 10% in implied volatility.
Realized volatility is even lower, in the 2% range. It becomes a challenge to extract enough premium that makes a trade worthy of our attention. We may get lucky to receive a 1.35-point credit on a 20-point spread going out two weeks! That is not much, but it's a symptom of low market volatility.
Further, the term structure of volatility, albeit steep, has the furthest date, hovering around 16%! Normally, we might see 20%+ volatility out four-five months. The current condition is defined by traders' lack of fear, plain and simple. A great environment for a premium seller to trade a market going sideways.
This is where we focus option premium selling. My partner and Real Money colleague Suz Smith, a gifted, talented and veteran trader, has created enormous value for clients and subscribers by focusing on high-probability, low-risk trade ideas. Her tactic is to sell put spreads and call spreads far out of the realm of hitting strikes, so that it would take an enormous move in the direction of her short strikes to lose money.
For put spreads, this involves selling a specific strike and covering that with a buy of a lower strike. For call spreads, it is selling a specific strike and buying a call higher. This defines risk in case a large move gets well out of hand. Note, that doesn't mean risk free; rather, it is risk-defined.
Now, that can happen at any time, but our history shows it may occur once out of 12 trades. Hence, we may encounter moments when we start to sweat, much like last month, when bear call spreads blew out.
The object here is to be far enough away by expiration, letting the clock work in your favor by letting the option decay as it should. Roughly 80% of all options expire worthless. The objective is to have the options go out worthless, or close to it. Suz has been successful (closed out for full profits or more) on more than 90% of her trades in 2017 (well over 30 initiated).
Getting paid to play is the goal here, and with low volatility you might expect premiums to be weak. You would be correct. However, the combination of more time and raising the level of the short strike can be used to find the optimal strikes that will expire worthless or close to it (that is the goal, to take in credit and let the options decay).
As we move closer to that holiday on May 29, look for these opportunities right now. We have many other holidays to come this year as well, so this might be a great time to experiment and learn how this is done. Reach out to Suz to discuss this sort of trading strategy at email@example.com.