Put Credit Spreads to Combat volatility spikes. & How I Trade it

Volatility is an important consideration for all option traders. One of the primary factors of the price of options on that security is the volatility of the underlying security. If the underlying security's price movements are frequently turbulent, the options will have more time value than if the stock is typically a sluggish mover. This is merely a result of option writers attempting to maximize the premium they receive in exchange for taking on the low profit potential and high risk of writing the option in the first place.

Similarly, "implied volatility" is the volatility value derived by an option pricing model when the option's actual market price is input. Trader expectations can cause it to vary. In other words, as volatility rises, the amount of time premium built into a security's options rises, whereas as volatility declines, the amount of time premium falls. This can be important information for traders who are on the lookout.

The Stock Market and Fear

During a downturn, the stock market tends to drop quickly as panic causes a frenzy of sell orders, and to rise more slowly. While this isn't always the case, it's a good rule of thumb to follow. As a result, when the stock market begins to collapse, option volatility rises—often quickly. This leads option premiums on stock indexes to grow considerably more than would be expected based only on the underlying index's price movement.

In contrast, when the market ultimately bottoms out and begins to rise again, implied volatility—and consequently the amount of time premium built into stock index options—tends to fall. This introduces a way for trading stock index options that could be valuable.

The CBOE Volatility Index is the most widely used indicator of "fear" in the stock market (VIX). The VIX index calculates the implied volatility of SPX options (which tracks the S&P 500). 1

Figure 1 shows the VIX at the top, the three-day relative strength index (RSI) below it, and the ticker SPY (an ETF that tracks the S&P 500) at the bottom. When the SPX declines, the VIX tends to "spike" higher.

The Put Credit Spread is a term that refers to the difference between

Put prices often rise in value when the stock market falls. Similarly, as implied volatility rises in tandem with stock index declines, the time premium built into put options often climbs dramatically. As a result, a trader might profit from this position by selling options and collecting premiums when they anticipate the stock market is about to turn around. Because selling naked put options implies taking on significant risk, most traders are understandably unwilling to do so, especially when the market is dominated by negative sentiment.

As a result, in this case, two things can help: an indicator that the selloff is abating or will abate soon, and the usage of a credit spread via put options.

A put credit spread, sometimes known as a "bull put spread," entails selling (or "writing") one put option at a specified strike price while simultaneously purchasing another put option at a lower strike price. Buying the call with the lower strike price "covers" the short position and reduces the amount of money lost on the trade.

Identifying when the stock market will reverse is, of course, a long-term goal for all traders. Unfortunately, there is no such thing as a perfect answer. However, one of the advantages of selling a bull put spread is that you do not have to be extremely precise with your timing. In truth, you just need to "not be badly incorrect" if you sell an out-of-the-money put option (i.e., a put option with a strike price below the current price of the underlying stock index).

We'll look for three things to determine when to start:

1. SPY is currently trading higher above its 200-day moving average.

2. SPY's three-day RSI was at 32 or below.

3. The three-day RSI for VIX was at 80 or higher before falling.

When these three occurrences occur, a trader may want to explore put credit spreads on the SPY or SPX.

Consider the signals in Figure 1 as an example. SPY was above its 200-day moving average on this date, the three-day RSI for SPY had recently dipped below 32, and the three-day RSI for the VIX had lately crept lower after exceeding 80. SPY was trading at $106.65 at the time. A trader may have bought 10 November 103 puts for $1.16 and sold 10 November 104 puts for $1.40.

• The maximum profit potential for this trade is $240 and the maximum risk is $760.

• These options have only 22 days left until expiration.

• The break-even price for the trade is $103.76.

To look at it another way, as long as SPY falls less than three points (or roughly -2.7%) over the next 22 days, this trade will show a profit.

The trader will keep the entire $240 credit gained when the deal was entered if SPY is over $104 at expiration in 22 days. Only if SPY was trading at $103 or below at expiration would the maximum loss occur. If SPY falls below a certain level, a trader may need to take action to limit their loss.

Final Thoughts

The spike in implied option volatility before the signal date, as measured objectively by the VIX index, fulfilled two functions in this case:

The VIX jump and subsequent reversal indicated that there was too much anxiety in the market, which is frequently a precursor to a restart of a continuous rally.

The increase in implied volatility also increased the amount of time premium available to SPY option writers.

In these situations, a trader can optimize their prospective profits by selling a bull put credit spread and taking in more premiums than if implied volatility was lower. This strategy should not be regarded as a "system," and it is certainly not guaranteed to create income. However, it is a good example of how combining numerous elements can result in unique trading opportunities for option traders.

This example involved combining the following factors:

Price Changes (requiring SPY to be above its long-term average)

Volatility is high (a spike in the VIX Index)

Probability has increased (selling out-of-the-money options)

Traders should be on the lookout for ways to skew as many elements as possible in their favor, increasing their chances of success.