A magic bullet, a panacea, a secret weapon — these terms are used a lot in trading circles, and the idea behind each is basically the same.

Everyone is looking for the one trick that’s going to lead them to the investment promised land. And while most of these tricks are just that — tricks — some secret weapons are legitimate profit-making tools.

Now, most options experts I know prefer to write options (i.e., they sell to open their options positions as opposed to buying them). Many of these experts claim that buying options is a sucker’s game. This is partially true, but only partially.

Surprise Volatility

I admit that I love to write options, but when I do buy options I take advantage of that much-sought-after secret weapon. This secret weapon is what I call, “surprise volatility.”

You see, when you buy options, you are betting on one thing — volatility, or movement of the price of the underlying stock, index or exchange-traded fund (ETF). If the stock doesn’t move much, then you lose.

Volatility is usually pretty predictable and moves in accordance with a log-normal curve, i.e., a bell curve. In fact, the Black-Scholes pricing model — a Nobel Prize-winning instrument used for measuring the fair value of an option — is based on this curve.

Volatility is the tendency of an underlying stock’s price to fluctuate up or down. The higher the volatility of a stock, the greater the likelihood that a stock price change will move an option deeper into the in-the-money range (that is, if its strike price is lower than the market value of the underlying shares).

As volatility goes up, both call and put values spike. Likewise, as volatility drops, both call and put values drop.

The challenge in predicting volatility is that the markets do not always move in accordance with a log-normal curve. A principle called chaos theory — which says that small occurrences significantly affect the outcomes of seemingly unrelated events — throws a wrench in the bell curve theory. Stocks and even futures can make moves that are much larger than what this curve prescribes.

Volatility Explosion

Over the past several turbulent weeks in this market, we’ve seen volatility explode off the charts. Just take a look at the chart here of the CBOE Volatility Index (VIX), our best measure of volatility.

The level of fear and volatility is almost literally off the charts, and that has big implications for options positions.

During the past few years, many stocks have made five- to 10-point moves, sometimes much more, literally overnight. And, on some occasions, they have dropped more than 50% in value based on unexpected news, earnings reports or takeover action.

On a log normal curve, there are three standard deviations on each side of the curve. Standard deviations measure the average distance of the data values from their mean. That is, the closer the data points are to the mean, the smaller the deviation.

Stocks can move as much as 10 standard deviations, way beyond the bounds of the curve.

Hence, the pricing model is undervaluing the options, especially the out-of-the-money ones at the ends of the curve.

In statistical terms, the tails of the curve are flat, which reflect risk, but it’s where large losses and profits can be realized. Therefore, surprise events prescribed in chaos theory can create instant home runs for option buyers and provide a secret edge — a secret weapon if you will.

Trading the Headlines

The influence of large and very-cash-flush institutional investors (thanks to the hoarding of cash during the sell-off) is one reason for the sudden gigantic moves in stock prices.

Hence, when a negative news item appears about a stock, the economy or the latest bailout propositions, the institutions move like a herd of elephants attempting to stampede through a small door. They all try to exit specific stock positions at the same time, and that causes the stock’s price to drop dramatically.

So, how can you protect yourself when you are buying options? I recommend buying options on stocks that have the greatest potential for surprise volatility. That means tech stocks, overvalued stocks with a lot of hype, single-drug pharmacy stocks up for FDA review, stocks in industries that are in flux and stocks with unpronounceable names.

The bottom line here is that surprise volatility is, in effect, the option buyer’s secret weapon. If you want to put that weapon on your side, then stick with any underlying instrument (i.e., stock, index or ETF) that is particularly vulnerable to surprise news or events. The higher the volatility (that is, the higher the perceived risk), the greater the premiums they will demand–and the bigger profits you can make.

To lean more about Ken Trester, read his bio.