When most traders start out with options, they feel overwhelmed. And I get it.
Options move fast. They have their own language. They’re volatile. The wrong advice can mean the difference between a profitable trade and a staggering loss.
I’ve been trading professionally for over 27 years. I’ve made every good bet you can imagine – and plenty of bad ones that wiped out my capital.
The good and the bad? Those experiences are what make Masters in Trading so special. You get to learn from my mistakes without making them yourself. And you discover the strategies that have helped me profit from the most profitable opportunities in the options market.
When it comes to options, understanding how concepts like volatility affect the market is crucial for success. That’s true whether you’re new or a veteran trader.
Look, volatility is a constant in the stock market. And it can be the biggest impediment to success if you don’t know how to manage it.
So today, I’m breaking down the key terms and strategies every options trader needs to understand how we manage volatility over the life of an options trade. I also want to show you the exact tools we use to measure volatility in the stock market.
Many of these terms might be unfamiliar to you. But after reading this, you’ll know everything you need to trade confidently.
Understanding Convexity, Skew and Variance
Convexity measures how sensitive the price of a financial instrument, such as a stock, is to changes in interest rates. If a stock’s options have high convexity, their prices will react more significantly to interest rate changes compared to options with lower convexity.
Here’s an example. You might notice that 5-year options have a convexity of 1.11 – higher than other options with convexity below 1.05. That implies these options are more sensitive to interest rate changes.
Traders who expect interest rates to rise might see high convexity as an opportunity for profit. Conversely, those expecting rates to fall might consider this a risk. After all, prices could move against them more quickly.
Volatility Skew refers to the difference in implied volatility between options with different strike prices but the same expiration date.
Positive skew means higher implied volatility for call options. Negative skew means higher implied volatility for put options.
Understanding the skew can help traders anticipate market movements and identify opportunities for buying or selling options at attractive prices.
Variance measures the volatility of an asset’s returns over a certain period. High variance indicates higher potential for price swings. This can be both an opportunity and a risk.
Here’s another example. If you expect significant movements in a stock’s price, high variance might make options trading strategies like straddles or strangles more appealing.
Outright vs. Spread Trading: Benefits and Risks
Outright Trading involves speculating on the direction of a single stock or option. The benefit is simplicity, as you’re only dealing with one instrument.
However, it comes with higher risk due to greater price volatility. Your position might suffer significant losses if market conditions change unexpectedly.
Spread Trading involves buying and selling two or more options simultaneously. The benefit is reduced risk since gains in one position can offset losses in another.
Spread trading can be less volatile. However, it’s more complex and requires a deeper understanding of the market. For example, a call spread might involve buying a call option at one strike price and selling a call option at a higher strike price.
Using Volatility Tools to Manage Market Risk
The CME Group Volatility Index (CVOL) provides real-time measures of expected volatility for key futures contracts. Traders can monitor to anticipate potential price swings and adjust their positions accordingly. This is valuable for hedging against potential losses or capitalizing on expected gains.
Factors to Consider When Choosing Between Outright and Spread Trading
- Market Conditions: Current market volatility can impact your decision. Higher volatility might make spreads more appealing as they can reduce risk.
- Implied Volatility: Analyze the implied volatility of different options. Volatility skew can indicate potential mispricing and opportunities.
- Risk Tolerance: Your individual risk tolerance should guide your choice. Outright trades might offer higher rewards but come with higher risks. Spreads can mitigate some risks.
The Importance of Skew in Options Trading
Skew helps you understand market expectations for future price movements.
Positive skew (higher call option volatility) suggests a bullish market outlook.Negative skew (higher put option volatility) suggests a bearish outlook. Analyzing skew can help you decide whether to buy or sell options based on perceived market mispricings.
Here’s an example: If out-of-the-money call options on a stock show higher implied volatility than put options, it indicates a positive skew. This might signal that traders expect significant upward movement in the stock’s price.
The Role of Variance in Options Trading
High variance can increase the potential payoff of a trade but also its risk. Traders need to balance the potential rewards against the risks when choosing their positions.
In a high-variance environment, you might choose options strategies that benefit from large price movements. Thes include strategies I mentioned at the top like straddles or strangles, where you buy both a call and a put option at the same strike price.
Summing It Up
Convexity, volatility skew, and variance are crucial for making informed trading decisions.
These factors provide insights into market forecasts and help you choose the best trading strategies. That’s true whether you’re outright trading or trading spreads.
Analyzing these elements can enhance your ability to manage risk and capitalize on market opportunities.
In addition to what you’ve just read, I’d like to point you toward a video explainer I put together demonstrating how I trade options skews across my services.
It’s a great addendum to the lessons in this article and a testament to the power we wield in trading volatility rather than direction. Just click here to check it out.
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