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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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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.

Below is the same diagram, this time labeled to show the loss amounts for the put position if Wynn Resorts were to rise to our stop-out price of $142.


WYNN December 140 puts, comparison of maximum loss amount at the $142 stop price
Click to enlarge

The Chart Values box now shows the loss amounts in the case in which Wynn Resorts rises to our $142 stop price. As of our September 6 target date, our loss would be -$207.40 if IV remained unchanged (Plot1). It would be only -$140.56 if IV increased to 28% (Plot2). That difference of $66.84 ($207.40 – $140.56) is the amount our maximum loss would be reduced if the 28% IV increase occurred.

The value for Plot100 is $-880.00. That is the amount of loss we would suffer if we held the 140 puts all the way until expiration and they expired worthless. It the full cost of the puts at $880 per contract. You can now see clearly why we don't want to hold them that long.
As you can see, modeling/diagramming software is absolutely required in order to estimate profit or loss for option positions that we plan not to hold until expiration. There is no "quick and dirty" way to do it.

We can now calculate our reward to risk ratio assuming unchanged IV.

Our reward/risk ratio is $449.66/$207.40 = 2.16:1.

The $449.66 figure is our profit with Wynn Resorts at the 130 target on September 6 and unchanged IV, the Plot1 value from Figure 3 above.

The $207.40 is our loss with Wynn Resorts at the 142 stop price on September 6 and unchanged IV, the Plot1 value from Figure 4 above.

Since our P/L at unchanged IV is greater than 2:1, we could continue to consider this trade.

9. Recalculate the 30-days-out profit and loss amounts, and 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.

In diagramming the trade, we plotted a line that was 30 days out with IV at the 28% average. So, it's now easy to calculate our Risk/Reward in that case as $506.28/$140.56 = 3.6 to 1.

Note how much that projected increase in IV would help us. Compared to the situation with unchanged IV, it would increase our max profit by $56.62 ($506.28 - $449.66), decrease our max loss by $66.84 ($207.40 - $140.56), and improve our reward/risk ratio from 2:1 to 3:6.

This is why we chose puts that were very close to the stock's original price, with a long time to run. In a situation where we expect an increase in IV, those puts will benefit the most.

Since our higher-IV Reward/Risk ratio exceeded our 3:1 minimum requirement, the trade was a go and on to step 10.

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

It did, so we did. We bought to open the puts at $8.80, using a limit order.

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

We entered an order to buy to close the puts using a market order, conditional on Wynn Resorts either trading at or above $142, or trading at or below $130, good until canceled.

A week after entering the trade, Wynn Resorts was almost where it had been when we entered. The puts were also still within $.05 of the price where we bought them. Our exit plans were in place, and all we had to do was to wait for one of our triggers to take us out of the trade.

Editor's note: This story by Russ Allen originally appeared on Online Trading Academy in two parts. Click here for Part 1 and here for Part 2.

To read more from Online Trading Academy, see:

Planes, Trains, and Automobiles

What's a Trade Without a Target?

Picking the Top
No positions in stocks mentioned.
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