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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.

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?

There was a strong demand zone at around $130. This was the area from which the last major rally was launched. We'd plan to sell the put options on Wynn Resorts reached that point.

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

Wynn had monthly expirations in August (9 days out), September (44 days) and December (135 days). The shortest expiration over 90 days was December. We want an expiration that will still have a large amount of time to go, at that time in the future when the stock hits our target. That is how we cash in on an increase in IV. A rise in IV increases only the time value portion of the option's value. We can only benefit from that if we sell the options when they still have plenty of time to go. We selected the December expiration date.

6. For that expiration date, find the first in-the-money (ITM) strike price.

Below is the option chain for Wynn Resorts.



With the stock at $139.68, the next higher put strike price was $140. The December 140 put was quoted at $8.75 bid, $8.85 ask. Midpoint between the bid and ask was $8.80. That's the price we'd plan to pay.

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 (details below).

For steps 7-9, we used the Tradestation module called OptionStation to diagram the trade and calculate profit/loss amounts. Below is a diagram showing the profit/loss amounts on the December 140 puts, at any Wynn price between $130 and $142.


WYNN December 140 puts, comparison of maximum profit at the $142 target price
Click to enlarge

In the diagram above, three separate lines are plotted:

The blue line (Plot1) shows the P/L as of a date 30 days in the future, assuming no change in IV.

The magenta line (Plot2) also shows P/L as of a date 30 days out but assumes IV increases to 28% (the average IV for this stock over the past year).

The green line (Plot100) shows the P/L picture 135 days out, at the December expiration date.

The chart values box at the lower left shows us how much profit the put would make with Wynn Resorts at the $130 price target, in each of those three situations. If the $130 target were reached 30 days from the entry date on September 6, our puts would make $449.66 each, if Wynn Resorts stayed at its ultra-low IV level (Plot1). If at that same date the IV were to increase to its 28% average, the puts would make $506.28 each (Plot2). That $56.62 difference ($506.28 vs $449.66) shows the effect that an increase in IV from the current 21% to the average of 28% would have on our P/L. The actual IV change could be greater or smaller than that. IV could conceivably even go down. But since Wynn Resorts was at a historic low in IV, we thought an increase was more likely.

The value for Plot100 in the chart values box is $108.00. That is the amount this same put would make at that same $130 price if the put were held all the way until expiration. The difference between the Plot1 value of $449.66 and the Plot100 value of $108.00 ($449.66 – $108.00 = $341.66), is the amount of time value that would be left in the puts on September 6 vs the December expiration, assuming unchanged IV. That $341.66 is the reason we do not plan to hold these puts any longer than 30 days. We need to sell the puts while they still have most of their time value. Now for step 8.

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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