I get it…

You’ve looked at options a million times. But something just doesn’t click.

When you think a stock’s going to go up, you buy a call option. And you buy a put option if you think a stock is going to fall.

Sounds easy, right?

Yet when you’ve put it into practice, things just didn’t work out for some reason.

Perhaps you got the call right on the direction of the stock.

But the option’s value only increased slightly. Maybe it even then went down!

The frustration can be enough for new traders to swear off options for life.

But if you grasp one basic concept that I’ll explain today, I hope you’ll be willing to give options a chance.

The Role of Volatility

Many option traders get stuck because they fixate solely on the price action of the underlying stock.

For example, if you buy a call option and the stock price rallies, you might assume the call option is going to jump in value.

To be fair, the stock price does have a big impact on the option’s value.

But there’s another factor that plays a major part… volatility.

If you buy a call option and volatility starts to fall, the option can lose value even if the underlying stock rallies.

Understanding volatility’s role is crucial to getting your options trade to work.

And to understand volatility, you need to take a step back and look at option “market makers.”

Because they can play a key role in your trade…

Who Are You Really Trading Against?

When you place an option trade, you’re buying from or selling to someone else. And chances are the other side of that trade will be a market maker.

Option exchanges employ market makers to “make a market.”

That means they provide liquidity so that traders like you and me can readily enter and exit option positions.

They quote prices and volume for the buy and sell sides of options. They do this with all sorts of different strike prices and expiry dates.

And when you enter an order with your brokerage, they often take the trade.

So you need to put yourself in their shoes…

Understanding the Market Makers

Say you decide to buy a put option. A market maker will sell it to you. They are effectively offering insurance on the underlying stock.

You pay them for the right to offload 100 shares per contract at the put option’s strike price.

The more volatile that stock becomes, the bigger the risk the market maker is taking. And they’ll want to be compensated more for taking on that risk.

So if you buy the put option when volatility is peaking, that can make it harder for you to profit.

Say you bought a put option on the S&P 500 due to political uncertainty, the outbreak of war, or poor economic data. Any of those events might spike volatility.

If the fear and panic fades, then volatility will likely decrease – along with the value of your put option.

So you might get the direction right. But a drop in volatility could lead to the value of your option falling.

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What to Look For

To avoid this, the ideal scenario is to buy an option when volatility is low but increasing.

If the stock heads in the right direction and volatility increases, then you’ve stacked the odds firmly in your favor. And you will likely bank a tidy profit.

Before I place an option’s trade, I look at the stock’s implied volatility.

I also make sure to check out the CBOE S&P500 Volatility Index (VIX). That way I can gauge the broader market’s volatility.

The VIX measures the volatility of the S&P 500. The higher the VIX is tracking, the higher the market expects volatility to be over the coming month.

On the left-hand side of the chart below, you can see the massive jump in volatility off the back of the COVID pandemic. And on the right-hand side, you can see another spike when the Japanese yen carry trade unwound earlier this year…

CBOE S&P500 Volatility Index (VIX)

Source: e-Signal

If you bought a put option right before volatility exploded during peak fear, you could have made eye-watering profits.

But the same trade just after that peak would have seen the value of your put option vaporize in front of your eyes.

Of course, these are both extreme examples. But as the chart shows, there have been plenty of volatility swings in between.

As an options trader, you always need to be aware of what volatility is doing… and use it to your advantage.

So when you next go to buy an option, start with the price action. You want to get the direction right.

But don’t place your trade until you’ve checked out volatility.

You want to catch a volatility wave just as much as get the stock direction right.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict