Making Your Own Volatility Bets – Option Spreads and Straddles

A lot of talk is going on about the VIX, also known as the CBOE Volatility Index. This index will track and correspond to the market’s expectation of 30 day volatility. What does that even mean?

I can show you how to make your own volatility bet by using options for a single company. For example Ford.

Ford is one of those companies that I believe will either prove itself as relevant in the coming years or fade into obscurity.

So I can make a bet that Ford will be either go past 15 dollars or slide down past 8 dollars by January 18th, 2019. For a relatively low bet of just 32 dollars I can make a decent profit if the stock dips below

Option Spread

Ford Spread Profit Chart

Stock Price Strike Price C Strike Price P Option Cost Gain Profit
0 15 8 32.00 800 768.00
1 15 8 32.00 700 668.00
2 15 8 32.00 600 568.00
3 15 8 32.00 500 468.00
4 15 8 32.00 400 368.00
5 15 8 32.00 300 268.00
6 15 8 32.00 200 168.00
7 15 8 32.00 100 68.00
8 15 8 32.00 0 -32.00
9 15 8 32.00 0 -32.00
10 15 8 32.00 0 -32.00
11 15 8 32.00 0 -32.00
12 15 8 32.00 0 -32.00
13 15 8 32.00 0 -32.00
14 15 8 32.00 0 -32.00
15 15 8 32.00 0 -32.00
16 15 8 32.00 100 68.00
17 15 8 32.00 200 168.00
18 15 8 32.00 300 268.00
19 15 8 32.00 400 368.00
20 15 8 32.00 500 468.00
21 15 8 32.00 600 568.00
22 15 8 32.00 700 668.00
23 15 8 32.00 800 768.00
24 15 8 32.00 900 868.00

Another option strategy that makes people feel better about themselves since they will almost always get something back, but costs more, is called a “straddle”. A straddle, in this case with Tesla, is a bet that the stock price deviates from a certain point. In the figure below, a bet is being placed that the price of TESLA will deviate away from $350 per share by January 18, 2018. The price looks big, $10,765 for this particular strategy. But look below and you will see the profit loss chart shows that nears $200 or goes over $430 per share you will start making money again. This particular example I would not trade because the option prices are too high.

Option Straddle

Tesla Straddle $350 Profit Chart

Stock Price Strike Price Option Cost Gain Profit
0 350 10,765.00 35000 24,235.00
10 10,765.00 34000 23,235.00
20 10,765.00 33000 22,235.00
30 10,765.00 32000 21,235.00
40 10,765.00 31000 20,235.00
50 10,765.00 30000 19,235.00
60 10,765.00 29000 18,235.00
70 10,765.00 28000 17,235.00
80 10,765.00 27000 16,235.00
90 10,765.00 26000 15,235.00
100 10,765.00 25000 14,235.00
110 10,765.00 24000 13,235.00
120 10,765.00 23000 12,235.00
130 10,765.00 22000 11,235.00
140 10,765.00 21000 10,235.00
150 10,765.00 20000 9,235.00
160 10,765.00 19000 8,235.00
170 10,765.00 18000 7,235.00
180 10,765.00 17000 6,235.00
190 10,765.00 16000 5,235.00
200 10,765.00 15000 4,235.00
210 10,765.00 14000 3,235.00
220 10,765.00 13000 2,235.00
230 10,765.00 12000 1,235.00
240 10,765.00 11000 235.00
250 10,765.00 10000 -765.00
260 10,765.00 9000 -1,765.00
270 10,765.00 8000 -2,765.00
280 10,765.00 7000 -3,765.00
290 10,765.00 6000 -4,765.00
300 10,765.00 5000 -5,765.00
310 10,765.00 4000 -6,765.00
320 10,765.00 3000 -7,765.00
330 10,765.00 2000 -8,765.00
340 10,765.00 1000 -9,765.00
350 10,765.00 0 -10,765.00
360 10,765.00 1000 -9,765.00
370 10,765.00 2000 -8,765.00
380 10,765.00 3000 -7,765.00
390 10,765.00 4000 -6,765.00
400 10,765.00 5000 -5,765.00
410 10,765.00 6000 -4,765.00
420 10,765.00 7000 -3,765.00
430 10,765.00 8000 -2,765.00
440 10,765.00 9000 -1,765.00
450 10,765.00 10000 -765.00
460 10,765.00 11000 235.00
470 10,765.00 12000 1,235.00
480 10,765.00 13000 2,235.00
490 10,765.00 14000 3,235.00
500 10,765.00 15000 4,235.00
510 10,765.00 16000 5,235.00
520 10,765.00 17000 6,235.00
530 10,765.00 18000 7,235.00
540 10,765.00 19000 8,235.00
550 10,765.00 20000 9,235.00
560 10,765.00 21000 10,235.00
570 10,765.00 22000 11,235.00
580 10,765.00 23000 12,235.00
590 10,765.00 24000 13,235.00
600 10,765.00 25000 14,235.00
610 10,765.00 26000 15,235.00
620 10,765.00 27000 16,235.00
630 10,765.00 28000 17,235.00
640 10,765.00 29000 18,235.00
650 10,765.00 30000 19,235.00
660 10,765.00 31000 20,235.00
670 10,765.00 32000 21,235.00
680 10,765.00 33000 22,235.00
690 10,765.00 34000 23,235.00
700 10,765.00 35000 24,235.00

Someone may have told you that in Blackjack insurance is a suckers bet, but if you ever looked into the counting strategy then in certain situations you should take the insurance. Currently I am only buying and writing call options at the time of this article and not utilizing spreads or straddles and have no intention of doing so in the next week or so. While the screenshots above are using market order types I strongly suggest to always trade using the limit order type on all option trades.

 

Set Your Target and Be Happy with a Profit

I purchased Twenty-First Century Fox (FOXA) for $26.77 near the end of September and sold it for just $29.00 yesterday. I could easily be upset about this sell, after all Fox is now trading at $31.15 with the news of Comcast’s supposed interest in purchasing a large stake of the company. Just last week Fox was in talks to sell some of its assets to Disney, so two potential suitors means a better price for Fox.

The reason I had to sell the shares I had for just $29.00 was because I had written a call option when I purchased they shares for exactly $29.00 per share with expiration date of November 17th. I figured an 8% gain within two months was a pretty good rate of return should I be forced to sell. My reason for buying FOX was due to it having a low P/E ratio and dividend, followed by the facts that it had fallen quite a bit from $32 per share in March. Having a profit margin about 10% and a return on average equity of over 20% this was a good candidate amongst other large media companies. Not to mention the “economic moat” that Fox has from its news competitors.

Writing the options yielded 64 cents per share, meaning the shares would have to exceed $29.64 for me to have to sell the stocks. The doubly whammy good news for Fox meant I had to sell the shares at a measly 10.7% profit  [($29.00 + $0.64) / $26.77] rather than a 16% profit [$31.15 / $26.77]. My conclusion is that I would have no idea of these pending acquisition talks, as I base my investment decisions usually on book value and economic moat evaluation. The option drove the stock sale, and now my liquidity is up.

It is easy to regret investments which could have made you more money. I regret not buying a whole bunch of bitcoin in 2011. However, instead as a investor you should be confident if your decisions are well informed and logical.

Is The Bear Here?

Is the bear here? Have six years of solid yields in the stock market going to be wiped away by a massive correction? Should you be worried?

I have no idea, but I’m prepared to a certain extent whether or not a bear yields its ugly face. You can do the same, as long as you are approved for options trading.

 

Strategy #1: Make sure you have put options covering or exceeding the amount of shares you have in companies – for example if you are holding 100 shares of Apple which is worth around $106.25 after falling almost 7% in the past five days, you should hold at least one put option of Apple. The strike price for the put option is where a lot of the magic comes into play, as if you buy a put option with a strike price above Apple’s current market value you are making a very conservative play that will be handsomely rewarded if Apple stock price falls but costs a moderate amount more than an option with a strike price around $100 for example.

In my real-price example I will use the March 20th, 2015 expiration date. The Put option with strike price of $110 (above the market price of AAPL which is $106.25) costs $850. The put option for $100 costs $370. The difference is $480, which is less than the difference in share price for a given options “basket” which is $625. That means that It makes more sense to buy the more expensive put option if the stock falls, because even if it falls past the lower strike price you will be making more money.

Let’s say Apple falls to $90 per share by March 20th – with the more expensive put option you make $20 per share in your basket minus the commission which comes out to a profit of $1150. If you had purchased the cheaper lower strike price option you would make $630. Of course you stand to lose more if Apple goes up by March with the first option, which is why options being supported by a long ownership of Apple makes sense.

Strategy #2: Short the stock market. Sell  shares of a company you don’t own with the intent of buying them back later at a lower price. This is a highly risky strategy as shorting a stock makes you liable to pay any dividends they issue from your account and without a call option to secure the short position the loss potential is astronomical. One company that is heavily shorted is Herbalife Ltd., which some hedge fund managers consider to be a pyramid scheme soon to be busted by the government. If you short the stock market you will make money in a bear market.

Strategy #3: Sell all of your stocks and invest in corporate bonds or bank CDs. This is sort of like giving up on high yield investing, find a bond that suits your risk level or go with a municipal bond that may offer tax savings at the state level. Even more risk averse you can put money into T-Bills, which is what countries like China have done to protect the value of their huge cash surplus.

Locking In Gains with Put Options

Are you too scared to sell the stocks that have made over 50% in the past year or two? Is it because you want to hold off on cashing in and paying a heft amount of capital gains tax? How about doing what the big banks do, buy put options! Put options go up and make money if the price of a stock goes below a certain amount by a certain time. That means if you buy put options for your most profitable stocks you will be essentially locking in profits while not having to sell these stocks which might be paying dividends.

The downside with put options is you must pay a price to buy the put option from an available seller and put options expire based on what their expiration date is. The longer the expiration on a put the more expensive it will be. Let’s say you were lucky enough to be able to purchase Alibaba at IPO pricing – $68 per share. Currently BABA trades at $106, so you’ve made $38 per share, not too shabby. However, you foresee or have fear that BABA may fall below $100 and want to make sure you lock in those profits while not making a short term sell. What you can do is buy put options to cover your stocks until October 2015. Or if you want to save some money you could also buy put options now to cover you until March and then re-evaluate your “options”.

Options are cheaper than their underlying security because they are worthless if they aren’t “in the money” when they expire – to understand these options concepts if your a newbie please read this, this, or this.

What’s a Bull Spread?

A bull spread is a type of call option that aims to profit off of a underlying security that has a specified percent increase. Most of the time investors aim for moderate or low price increase.

An example of a bull spread is to buy a call option for Apple for a expiring three months from now for a strike price of $130 per share. Apple trades at $113.99 as of right now (premarket 12/29/2014). The call option costs $1.37 market price, so for a single option you will be paying $137 (options come in stacks of 100). If you wanted to lower that cost all you’d have to do is sell another call option for Apple for say $140. You’ll get 50 cents for this, so you’ll lower your total cost for this “play” to 87 cents. So pay $87 rather than $137 to make at MOST $10 per share, or $1,000.

I personally am not a fan of the bull spread because of the fact that you’re limiting your winnings, it’s like buying insurance on your winnings. I must prefer having unlimited UPSIDE potential with a put option in place as INSURANCE. Even so, when you’re hedging your investments you are limiting your profit potential.

You can also do what I call a “bear spread” by buying a put option and then selling a put option for a even lower strike price. This would be in anticipation for a moderate downfall in the price of an underlying security. I would personally never do this, it would almost take a wizard or oracle to predict such a price fall to such a degree. You’re better off shorting a stock then paying such hefty premiums for these options.

If you’re interested in seeing what a bull spread looks like on a profit-loss graph here it is below:

Call option March 20 leg 1 buy $130, leg 2 sell $140

Call option March 20 leg 1 buy $130, leg 2 sell $140