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How to Find Options Opportunities With Low Volatility

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Here are the steps you need to follow when buying options.

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I have discussed here and here how to find option opportunities by looking for stocks with unusually expensive options. A natural question is whether there are opportunities in stocks with options that are unusually cheap. And there are. In fact, if we can identify stocks that are at strong demand levels or supply levels and that also have very cheap options, we have the most straightforward and potentially most profitable type of option trade.

The process of identifying these opportunities has a set of steps that are a bit different than those for expensive options. Here, rather than selling, we will be buying options. We'll buy calls if we're bullish or puts if we're bearish, though it's more complicated than this.

Here's we need to do to take advantage of cheap option opportunities. First, I listed the steps. Then, we'll walk through an example and describe each step.

1. Locate stocks with unusually low implied volatility (IV) relative to their own IV history. Low IV means cheap options.

2. Using a daily price chart, determine if we have a good reason to be strongly bullish or strongly bearish on each stock. This will be the case only if the stock is near (within an average day's range of) a high-probability turning point – a high-quality supply or demand level. Furthermore, there must be plenty of room for the stock to move after its reversal, enough for at least a 3:1 reward-to-risk ratio. Reject all the stocks that fail this test. This will eliminate most of the possibilities. The remaining stocks, if any, are our best opportunities.

3. Identify the stop price that we would be using if we were going to trade the stock itself. At what price would we exit the trade if it went against us?

4. Identify the target price for the next 30 days. At what price would we take our profit and exit the trade if it went our way during that time?

5. On the stock's option chain, locate the nearest monthly expiration date that is more than 90 days away.

6. For that expiration date, find the first in-the-money (ITM) strike price. If we are bullish and using call options, that is the next strike price below the current stock price. If we are bearish and using put options, it is the next strike price above the current price.

7. Calculate the profit amount with the stock at the target price and IV unchanged 30 days from now. You must use option diagramming software for this.

8. Calculate the loss amount with the stock at the stop price and IV unchanged 30 days from now. Reject the trade if the 30-days-out reward-to-risk ratio is less than 2 to 1.

9. Recalculate the 30-days-out-profit-and-loss amounts and the reward-to-risk ratio assuming that IV increases back to its one-year average. Reject the trade if the reward-to-risk ratio is not at least 3:1.

10. If all still looks good, place the trade.

11. Enter the order(s) to unwind the trade if the underlying hits the stop price.

This may seem like a lot of steps just to buy calls or puts. Maybe so, but they're not that tough, and each one is necessary. Leaving out one or more of these steps is what causes most new option traders to lose money.

Let's look at an example.

1. Locate stocks with currently unusually low implied volatility (IV)

The absolute numbers for implied volatility cannot be compared between stocks – there is no IV number that is absolutely low or high. The important thing is whether a stock's current implied volatility is low or high for that stock.

In this example, I wanted stocks whose current implied volatility are in the bottom 5% of the past year's range of IV. For example, if a stock's implied volatility over the past year has ranged from 10% to 50%, then it has a 40-point range (50 – 10). Five percent of 40 points is 2 points. So, if the current IV were between the low (10) and the low plus two points (10 + 2 = 12), then it would be in the bottom 5% of its range. I scanned for these types of stocks.

As mentioned above, I use a scanner integrated into my trading platform. Trading platforms and standalone products offer options scanners. I ran a scan for stocks whose IV percentile was 5% or less. In my scan, I also filtered out stocks whose prices were below $15 or whose daily average volume was less than a million shares a day.

On August 8, this search turned up 39 stocks.

2. Using a daily price chart, determine if we have a good reason to be strongly bullish or strongly bearish on each stock.

Viewing each stock's chart in turn, I rejected most within a second or two because they clearly were not near any kind of supply or demand zone. One good one, though, was Wynn Resorts (NASDAQ:WYNN). It was in process of failing at a major supply zone. After recently making a new, lower high at $141.64, it was currently at $139.68. This was well within the $2.88 daily ATR (average true range) of that $141.64 high. It passed our test for a strong, bearish picture. Our plan would be to buy put options, which increase in value as a stock's price goes down.

Wynn's price chart is shown below.


Click to enlarge

3. Identify the stop price that we would be using if we were going to trade the stock itself. At what price would we exit the trade if it went against us?

In this case, that would be the recent high at $141.64, plus a little breathing room, up to $142.00. If Wynn exceeded that, then our bearish expectations would be shown to be incorrect, and we'd take our loss while it was small.
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No positions in stocks mentioned.
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