Option Trading Adjustments Based on Volatility

In today’s article you’ll find tips about managing an Options Portfolio based on Volatility in the stock market. We’ll explore adjustment concepts that can be applied to any type of option strategy such as the famous Iron Condor, the Butterfly Spread, Calendar Spreads as well as all the others.

Right now as we write this article in 2008, the VIX is at its higher range for the last couple of years, causing options to be expensive. So if making adjustments at the present time, each trader needs to check where volatility is and forecast where it is leading to. Should we really purchase expensive, inflated options, or should we sell them to somebody else? What is the most recent volatility forecast in today’s stock market?

Many investors are trading options without an education on option Greeks or volatility. To find consistent success on the markets, one must really understand how volatility affects an option price as well as an option spread. For example, credit spreads rise when the volatility rises. Why? Because when IV rises, the time premium of an option also goes up and increases the price of the contract. This in turn increases the spread. If we don’t understand the fundamentals of option trading, we won’t know how to make good decisions to manage our accounts.

LOOKING AT A HYPOTHETICAL OPTIONS POSITION

Let’s say that we have on an Iron Condor, and the market has been in an uptrend for two weeks. If this is the case, then we might be looking at an adjustment right? We are getting close to our short strike, and we need to do something to manage our risk. In this situation the IV of the asset has probably been dropping, since the IV normally moves the opposite direction of the underlying being traded. So, what do we do? Well, if the IV is at support and the technicals indicate that it might rise again, then we’d be looking at doing a positive Vega adjustment.

Ok, so now we have determined that the IV is on support, and we think it’s going to rise. Well, this means that the market might come back down also. So, do we do nothing at all? Well, that might not be such a good idea because our current position is at risk. So even though we forecast the market is coming back down, we still put some insurance on our trade. We have to avoid catastrophic losses if we want to be successful in the long run. So, in this case, we hedge our portfolio or position with a positive Vega strategy, one that will benefit from a rise in IV.

There is really an unlimited number of ways to create a positive Vega position, but the most common positive Vega spreads are Debit Spreads, Short Butterflies, Broken Wing Butterflies (OTM), Short Condors and Calendars. In our mentoring course we discuss option strategies and adjustments in detail.

To conclude, if the stock market moves against you when you are in an option spread, then always study the IV of your underlying asset. Knowing what is going on with volatility can really help you make better decisions on managing your portfolio. This will definitely reduce your exposure to risk while increase your chances of being a profitable trader.

Learn more about Option Trading and Volatility. Stop by San Jose Options Mentoring and receive a FREE 45 MINUTE VIDEO on Option Greeks and see what this new knowledge can do for you.