Mispriced Volatility Could Set Up Gains
Traders like to say that they trade prices, not indicators. This is true when considering the role of popular technical indicators. The value of the RSI, the relative strength index, or the MACD indicator, are not tradable, nor are they particularly meaningful to many traders.
But, traders depend on changes in the level of prices to make a profit. This does mean at least one indicator is useful. That’s volatility.
Volatility is often talked about but many investors find that it is difficult to measure. In the traditional, and popular, sense, it is. VIX, for example, is the widely followed volatility indicator. That is a difficult index to measure, but many traders still profit from the indicator.
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Calculating Volatility, In Trader Terms
For a trader, volatility can be measured in simpler terms. Instead of calculating implied volatility of options or even the historical volatility in terms of standard deviations, the trader could just find how much a stock moved over a certain amount of time.
Like most indicators, this idea can also be applied to exchange traded funds (ETFS). An ETF tracks a basket of stocks or an index. Sometimes, as in the chart below, the ETF can track the price of a commodity.
This is a chart of United States Oil Fund, LP (NYSE: USO). It tracks the price of oil. The indicator at the bottom of the chart is found with a simple formula:
This is simply a trader’s tool rather than an exact presentation of volatility in the sense that it is defined in the academic world. It tells us the percentage move over an eight week period. The formula can be changed to measure any time frame.
Applying This Indicator, In Trader Terms
In simple terms, we could use this indicator to employ a strategy that benefits from mispriced volatility. For example, we could see that average volatility for USO has been quite high. The horizontal line in the lower part of the chart is drawn at the 8% level.
Over the past year, the average range of the price actions has been 13.85% for USO. This is over an eight week period.
Now, we could look for options that deliver a payoff if volatility is more than options are currently pricing in.
Oil is being used in this example because a large move in oil is likely. Obviously, the indicator we have developed shows that volatility is usually large in the ETF. And, oil is now moving on news so it could move even more than average.
Last week, President Trump tweeted, “Oil prices are artificially Very High! No good and will not be accepted!” According to The Wall Street Journal,
“The president’s comments came as the Organization of the Petroleum Exporting Countries (OPEC) and other major producers outside the cartel, including Russia, gather in Jeddah, Saudi Arabia, to assess compliance with a coordinated plan to hold back crude production.
Responding to Mr. Trump’s tweet on the sidelines of the ministerial monitoring meeting, Saudi Arabian Oil Minister Khalid al-Falih — the de facto head of OPEC — said “there is no such thing as an artificial price.” Markets, he added, “determine prices.””
Whether the upcoming news on oil is good or bad, this ETF is likely to make a relatively large move.
Volatility Seems Certain
When we expect volatility, but cannot forecast the direction of the price move, a long straddle can be used. This strategy is a combination of buying a call and buying a put, both with the same exercise price and expiration date.
Together, these two options contracts create a position that should profit if the stock makes a big move either up or down.
The strategy hopes to capture a quick increase in implied volatility or a big move in the underlying stock price during the life of the options. The risks are known when the trade is opened and the potential gains can be large. This is shown in the diagram below.
Source: The Options Industry Council
The maximum gain on a straddle is, in theory, unlimited. The profit at the expiration date of the options will be the difference between the stock’s price and the strike price, less the premium paid for both options. There is no limit to profit potential on the upside, while the downside profit potential is limited only because the stock price cannot go below zero.
The maximum loss is limited to the amount of premiums paid to open the position. The worst that can happen for a trader with a straddle position is that the stock price holds steady. If the stock’s price on the expiration date is exactly equal to the exercise price of the options, the options expire worthless, and the entire premium paid to put on the position will be lost.
A Specific Trade in USO
To trade this idea, we could trade options on USO.
The straddle can be opened using options expiring on June 15 with an exercise price of $13.50. The June 15 $13.50 call is trading at about $0.60. The June 15 $13.50 put is trading at about $0.40. The total cost to open the trade is about $1.00, before commissions which should be relatively small at a deep discount broker.
The total premiums add up to about 7.3% of the price of USO. The question is whether or not a move of that size is likely within the next few weeks. Given the current state of the market, it seems safe to assume that a significant price move is likely. Whether that move is up or down, this trade could profit.
The long straddle is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide the potential for gains and defined risk that could be lower than owning the stock. This strategy should also have a high probability of success.
These are the type of strategies that are explained and used TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.