Options Volatility Says Keep it Simple Here

September 3, 2018

Stocks are still near all-time highs, volatilities are once again compressed, earnings season is behind us, and some bullish runs in individual names are looking extended. Coming out of Labor Day Weekend, the game plan should be to keep it simple until things change.

I’m often asked how I choose which strategy to express our market opinion. The answer is subjective and depends on many factors. Here is a non-exhaustive list of things that matter to me:

  • What’s the trend of the underlying?
  • Where is support and/or resistance?
  • How cheap/expensive are the options?
  • Where is there liquidity in the options chain?
  • Is a quarterly earnings announcement on the horizon and should I be concerned about the event
  • How strong is my conviction on future direction? Etc.

As I scan around the market right now, I see bullish charts everywhere. But it doesn’t make me blindly bullish. If history is my guide, I know that one has to be prepared for just about anything during the September through November stretch of the calendar.

Does this mean I should dial back my bullish bets? Not necessarily.

As it stands currently — thanks to low volatility being priced into many of the most bullish names out there — calls and puts are priced pretty affordably across the marketplace. Additionally, since the market and certainly many individual names may be a bit extended, risk of a reversal or significant pause feels a little higher to me here.  In situations like this, it makes sense to place my bullish or bearish bets using straight long calls or puts. There is no reason to wade into the deep end of the complex option spreads pool when we can get all the participation we need, with clearly defined and easily manageable risk, with simple long calls and puts.

Subscribers to All Star Options have heard me mention repeatedly that I like to purchase 25 delta options when I go straight long calls or puts. These are out-of-the-money options that will expire worthless if the underlying stock does not move meaningfully in my direction. The beauty of 25 delta options is they have a (back-of-the-envelope math) 25% chance of the stock trading through their strike at some point before expiration. To me, this strikes the right balance between having an opportunity to profit from the trade with low cost of participation (thanks to being out-of-the-money) if the move never quite materializes.

As a side note, if anyone is currently holding any long stock positions that are making them nervous, the cheap options premiums make considering purchasing some cheap puts as protection, or executing a “stock replacement” strategy (where one could sell their long stock and purchase an equivalent amount of long calls, limiting their downside) attractive ideas.

So in the coming weeks when placing my bullish (or bearish) bets, I’ll be giving preference to simple long call or put plays. The volatility and cheap prices makes the unlimited upside inherent in long options an attractive proposition.

When the market changes, so be it, I’ll change with it.

~ @chicagosean

[this post originally appeared on allstarcharts.com]