Financial Literacy

Volatility Trading Strategies for the Beginning Trader

Volatility trading strategies are, as the name suggests, strategies you can use to profit from volatility trading, which is different from traditional trading.

In conventional investing, when an investor buys a stock, it very much matters which direction the stock price goes. If the price goes up, they will make money, and if it goes down, they will lose money. The opposite is true in short selling. When you short sell a stock, you make money when the price goes down and you lose money when the price goes up.

Volatility trading can be different because when you trade on volatility with the right strategies, you’re able to make money no matter which direction the underlying stock goes. That’s because when you trade volatility, what matters is the overall size of the price movement and not which direction the price is moving in.

Volatility trading can be a great way to make money, but it also has its downsides. Because of this, you should absolutely make sure to use smart volatility trading strategies when getting into this game. In this article, we will cover a few of these that beginning traders can try.

A businessman at a chess board devising a strategy. Do you know these volatility trading strategies?

Some Volatility Trading Strategies

1. Buying Put Options

The first of the volatility trading strategies we’ll look at is buying put options. A put option is the option to sell a stock at a given price. For example, let’s say you buy a put option on Coca-Cola Consolidated Inc (Nasdaq: COK) with a strike price (a fixed price that the owner of the option can buy or sell) of $250. You will have the option to sell a share of Coca-Cola at $250. If the price of COK goes above $250, the put option is considered “out of the money.” Because you wouldn’t want to exercise your right to sell COK at $250 when you could sell it for higher without the put option.

Let’s say, however, that Coca-Cola drops below $250 – say to $245. Now your option is considered “in the money.”  If you bought a share of Coca-Cola at $245 and exercised your right to sell it at $250 with the put option, you’d make an immediate $5. (Less the price you paid to purchase the option itself – known as the premium).

If you are bearish on a stock and think it will decline over time, you can buy – or “go long” – on a put option to profit on the stock’s price decline. As an example, let’s say Coca-Cola is currently selling for $250, and you think it will decline in the next six months. To attempt to profit, you purchase a put option on Coca-Cola with a strike date six months out and with a strike price of $245. In addition, you pay $5 to purchase the option.

In order to make money on this put option, you will need the price of the stock to decrease by more than $10. This is because the put option is only in the money if the stock price declines from $250 to $245. But then you also have to factor in your $5 initial investment in the put option. Now, say the price of Coca-Cola drops to $235 by the strike date. You will make the following: $245 {the strike price} – $235 {underlying asset price} – $5 {your initial investment} = $5.

Now that may not seem like much. But consider this – your initial investment was only $5 to begin with. To calculate the total return on your investment you divide your return by your initial investment – $5 / $5 = 100%. A quick triple-digit return! That’s what makes this a powerful volatility trading strategy.

2. Selling Call Options

The second of the volatility trading strategies we will look at is selling or “writing” call options. A Call Option is an option to buy a share of stock at a given price. When you buy a call option, you do so because you are bullish on the underlying security. For example, let’s say Coca-Cola is currently trading at $250, and you think the price will appreciate more than $10 in the next few months. You may buy a call option with a strike price of $255 for a $5 initial investment.

If the stock increased to $265 by the strike date, you could exercise your call option. This gives you the right to purchase the stock at $255. Then, you immediately sell the stock for $265 on the free market. This gives you a $10 spread. When you subtract your initial investment of $5, you are left with a profit of $5 on the trade.

Now, we already discussed that one bearish volatility trading strategy you could use is to buy put options. But another one you can use is to sell call options. Whereas buying a call option is a bullish strategy – you expect the price of the underlying stock to increase – selling a call option is a bearish strategy.

When you sell a call option, you get to keep the premium you earn.  For example, if you sell a call option on Coca-Cola with a strike price of $260 for $5, you get to keep that initial $5 premium you earned from the trade. Now, if the price of Coca-Cola decreases as you expect it to, the call option will remain out of the money.  And then it will not be exercised. In this case, you get to keep your entire premium as your return on the trade.

On the other hand, if Coca-Cola increases to $262, the call option is going to be exercised. As the seller of the call option, you are now obligated to sell shares of Coca-Cola to the option holder for $260. This means that if you had to purchase the stock on the open market for $262 and then sell it to the option holder for $260, you would lose $2 on the exchange. This $2 would then be deducted from the premium you earned to calculate your total return, so $5 – $2 = $3. On the plus side though, you still made money.

3. Straddles and Strangles

Straddles and strangles are volatility trading strategies that use more than one option position. For example, in a straddle, you trade two options with the same strike price and date – one is a call and one is a put.

Here’s how the short straddle works. In a straddle, you sell one call option and one put option with the same strike price and date. When you sell these options, you receive both premiums.

Your expectation when using a straddle approach is that price volatility will be low. If this turns out right, you will get to keep either most or all of the premiums you earned.

A short strangle is similar. However, there is a key difference. In a short strangle, strike prices on the call and the put are different. Usually the call price is above the put price. Both are out of the money. And both options are about the same distance from the underlying stock’s current price.

So if the stock is trading at $10, you might sell the call at $12 and the put at $8. While this strategy generally earns you a lower premium than the straddle, it also cuts down on some of your risk.

Concluding Thoughts on Volatility Trading Strategies

Volatility trading can definitely earn you hefty returns. At the same time, it can be risky. By sticking with volatility trading strategies that you fully understand, you will be able to better manage your risk and make money in the market.

If you’re interested in learning more about volatility and options trading, I highly suggest signing up for the wonderful and free Trade of the Day e-letter in the subscription box.

Hopefully, you now have a better understanding of some beginner volatility trading strategies. And make sure to watch for the next article in this series on the question: how do you trade volatility?


About

Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.

He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.

His primary interests at Investment U include personal finance, debt, tech stocks and more.

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