I’ve mentioned numerous times that we are in a volatility bull market.
Jason Goepfert of Sundial Capital Research recently said, “The average volatility gauge across markets is in the top 2% of their yearly ranges. That’s an incredible bout of cross-asset concern that we’ve rarely seen in the past 30 years.”
Courtesy of Sentimentrader.com
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Even the volatility of volatility is nearing an extreme.
And as I’ve mentioned numerous times in the past, the best way to take advantage of the volatile times is to sell options. I mean, I would argue that it is always best policy to sell options premium using a variety of options selling strategies, but right now is one of the few times that we don’t have to search for opportunities. Options selling opportunities are available across the board, regardless of your directional bias.
Let’s take a look at a few potential bearish trades in the United States Oil Fund (USO). The reason I want to look at a few bearish trades over bullish is because of the current historic overbought levels we are witnessing in USO. They’re the highest in a decade. And again, I’m not necessarily looking for a sustained push lower, rather more of a short-term pullback from overbought extremes. Basically, I want to see mean reversion work its magic. But I know if it doesn’t and USO continues to trend higher there are several options strategies I can use that give me a huge margin of error. Let’s take a look a few trades below.
As you can see in the chart below, the ETF has gained roughly 55% year-to-date, 25% of that since the beginning of March.
As a result of the decline in USO, implied volatility, as seen through IV rank and IV percentile, has pushed significantly higher.
IV Rank
The IV rank for USO recently hit an extreme reading. Typically, when we see the IV rank of a highly liquid ETF or stock hit this type of extreme volatility reading, it marks a potential opportunity to start selling some premium regardless of whether or not one is bullish or bearish on the underlying security.
Courtesy: SlopeofHope.com
Expected Move
Let’s say I wanted to go out roughly 30-45 days until expiration. The April 14, 2022 expiration for USO has an expected move ranging between 27.50 and 34.
Knowing what the market anticipates for the expected range gives us a good idea what strikes we prefer to use, especially if we are using a high-probability approach to trading.
To keep things consistent on both the call and put side I’m going with the strike just outside the one standard deviation move (blue dotted line).
Bearish Trade – United States Oil Fund (USO) – 84% Probability of Success
Let’s take a look at the April options chain for USO with 37 days until expiration. My preference is to use options that have roughly seven to 60 days until expiration. Once we have an expiration cycle in mind, we can then proceed to locate a call strike that has roughly an 80% probability of success.
The 108 calls just outside the blue dotted line, with an 84.04% probability of success, is where I want to start. The short 108 call defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.
Basically, as long as USO stays below the 108 call strike at expiration we will make a max profit on the trade. So, USO can go up, sideways, down—it doesn’t matter, as long as USO stays below the 108 calls at expiration we will have an opportunity to make a decent profit.
Time decay also works in our favor, so as we get closer and closer to expiration our premium will erode. As a result, we should have the opportunity to take the bear call spread off for a nice profit prior to expiration. Again, we can be completely wrong in our directional assumption and still make a max profit on the trade. Just another reason why I prefer to sell options over buying them.
Once I’ve chosen my short call strike, in this case the 108 call, I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide spread to buy.
The spread width of our bear call helps to define our risk on the trade.
The smaller the width of our bear call spread the less capital required, and vice versa for a wider bear call spread. When defining your position size knowing the overall defined risk per trade is essential. Basically, my spread width and my premium increase as my chosen spread width increases.
For example, let’s take a look at the 6-strike, 108/114 bear call spread.
The Trade: 108/114 Bear Call Spread
Simultaneously:
Sell to open USO April 14, 2022 108 strike
Buy to open USO April 14, 2022 114 strike for a total net credit of roughly $0.57 or $57 per bear call spread.
- Probability of Success: 84.04%
- Total net credit: $0.57, or $57 per bear call spread
- Total risk per spread: $0.57, or $57 per bear call spread
- Max Potential Return: 10.49%
As long as USO stays below the 108 strike at expiration in 37 days, I have the potential to make 10.49% on the trade. In most cases, I will make slightly less, as the prudent move is to buy back the bear call spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.57, I want to buy it back when the price of my spread hits roughly $0.15 to $0.30.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration lead the way for our decisions. But taking off risk by locking in profits is never a bad decision and by doing so, we can take advantage of other opportunities the market has to offer.
To keep things consistent on both the call and put side I’m going with the strike just outside the one standard deviation move (dotted line).
Bearish Trade – United States Oil Fund (USO) – 76.5% Probability of Success
Let’s take a look at a slightly more aggressive trade. The April options chain for USO with 37 days until expiration fall at the top of the expected range for USO.
The short 100 call defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.
Basically, as long as USO stays below the 100 call strike at expiration we will make a max profit on the trade. So again, USO can go up, sideways, down—it doesn’t matter, as long as USO stays below the 100 calls at expiration we will have an opportunity to make a decent profit.
Time decay also works in our favor, so as we get closer and closer to expiration our premium will erode. As a result, we should have the opportunity to take the bear call spread off for a nice profit prior to expiration. Again, we can be completely wrong in our directional assumption and still make a max profit on the trade. Just another reason why I prefer to sell options over buying them.
Once I’ve chosen my short call strike, in this case the 100 call, I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide spread to buy.
The spread width of our bear call helps to define our risk on the trade.
The smaller the width of our bear call spread the less capital required, and vice versa for a wider bear call spread. When defining your position size knowing the overall defined risk per trade is essential. Basically, my spread-width and my premium increase as my chosen spread-width increases.
For example, let’s take a look at the 5-strike, 100/105 bear call spread.
The Trade: 100/105 Bear Call Spread
Simultaneously:
Sell to open USO April 14, 2022 100 strike
Buy to open USO April 14, 2022 105 strike for a total net credit of roughly $0.84 or $84 per bear call spread.
- Probability of Success: 76.56%
- Total net credit: $0.84, or $84 per bear call spread
- Total risk per spread: $0.84, or $84 per bear call spread
- Max Potential Return: 20.19%
As long as USO stays below the 100 strike at expiration in 37 days, I have the potential to make 20.19% on the trade. In most cases, I will make slightly less, as the prudent move is to buy back the bear call spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.84, I want to buy it back when the price of my spread hits roughly $0.40 to $0.20.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But taking off risk by locking in profits is never a bad decision and by doing so, we can take advantage of other opportunities the market has to offer.
Risk Management
Since we know how much we stand to make and lose prior to order entry we can precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) it allows not only the Law of Large Numbers to work in your favor … it also allows you to sleep well at night.
I also tend to set a stop-loss that sits 1 to 2 times my original credit. In the first example, I sold the 108/114 bear call spread for $0.57. As a result, if my spread reaches $1.14 to $1.71 I will exit the trade.
In the second example, I sold the 100/105 bear call spread for $0.84. As a result, if my spread reaches $1.68 to $2.52 I will exit the trade.
Summary
As I have stated many times, there are numerous other options strategies we could use, like an iron condor, jade lizard, bull put spread or various ratio spreads, etc., but I wanted to keep it very simple today. Obviously, everyone will have a different idea as to what makes sense given their level of risk tolerance and market bias.
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Newsletter for education, research and trade ideas.