Trade Strategy for 24hrs or less, kind of day trading options…

Here’s a new kind of post at Vol Trader Blog, a theoretical trade strategy.

I get lots of questions about ‘day trading options’.  Personally, I feel day trading options is very difficult.  Options can be used for directional day trades in order to get leverage over trading the underlying equity but in my opinion in very limited ways.  Since this post is not about directional trades, stay tuned and at the end of this post I’ll add a note my opinion of this topic…

Today, I’d like to talk about a strategy that I’ve found works very well.  Technically it’s not a ‘day trade’ because you hold overnight, but sometimes you get a quick profit and you’re out in less than 24 hrs.

The setup here is very important.  I use the Live Vol Pro software ( http://www.livevol.com )to scan for “Exploding IV30”.  Live Vol Pro defines this scan as “symbols where the IV30 has gone up 30% in the last week”.  I further narrow this down to symbols where the IV30 has surged today or yesterday.

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My trade logic:  Find a stock where the front month IV has surged and buy a calendar just below the stock price.  Usually, when the IV surges it means the stock has made a bearish move.  The longs scramble to buy puts to protect their long position driving up the price of the OTM puts and hence IV. 

If during the next session the stock moves higher the front month IV will drop more than the back month.  This is due to the longs selling their front month put protection.  This is the desired move you’re looking for, however, if the stock moves down again the next session you may still make some money.  Because the back month puts have a higher Vega, a move up in back month IV has a greater effect than the same move on the front month.  Additionally, because your short strike is just below the underlying price, your calendar spread is always slightly short delta.  This may offset any loss due to IV.  This kind of trade seems to work best with 20-30 days remaining in the front month. 

Usually, I hold these trades longer than 24hrs too. The Calendar spread is a very forgiving trade… They are very small delta and gamma in the short term.  This means large moves in price don’t effect them that greatly.  Also, time is always on your side as they are Theta Positive over  a large range of underlying prices.

Here’s an example (not trade recommendation):

Using Live Vol Pro’s scan for exploding IV30, I found MED (Medfast Inc.)  First I check to make sure there is nothing in the fundamentals that may affect it such as M&A, earnings, dividend, etc…

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Here’s the Live Vol Pro chart of IV30 for two months (click to enlarge):

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The trade: buy the Jun – Sep $30 put calendar for $2.68 ten times with the underlying trading at $30.90.  You’re buying 82% IV and selling 87% IV.

The think or swim P&L chart looks like this (Click to enlarge):

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With portfolio margin the requirement is only $750. 

Exit strategy: I’m looking for a minimum profit of 20% of margin requirement or $150 per 10 contract size.  At $1.50 per contract, commission is $30 each direction or $60 total.  I will wait and see what happens.  Usually, I take a partial profit if it’s given to me right away and hold part. 

NOTE: as discussed above, my opinion on directional day trading options:  I really never do this, but the best way I see to day trade options is to buy ITM puts when you feel the underlying will decline.  This way you make money on negative delta and positive vega.  Buying calls is a losing proposition when you’re bullish.  Even if the underlying moves up giving you gains due to positive delta, you will lose on your positive vega as IV drops as the underlying moves up.  Again, as the underlying moves up the longs will sell their put protection causing IV to drop and due to put-call parity the call IV drops as well.  In my opinion, don’t directionally day trade options.  Use the underlying and even better, futures, but that’s a whole other discussion…

Thanks for reading Vol Trder Blog, Lawrence

6 Responses to Trade Strategy for 24hrs or less, kind of day trading options…

  1. Interesting trade. Do you also look for any parameters with your back month volatility? Meaning, would you want your Sep vol (in this case roughly “IV120”) to be a given amount less than your front month? In your scenario where it’s still possible to make money on a stock decline due to the positive Vega…I think one cavaet is that long dated Vega is going to be less variable than the short term. That’s one aspect of the combined Vega calc (ie, in TOS) that makes things a little deceiving, because really you have to consider June and Sep vega separately (I’ve learned this the hard way before).

    • Hi Ryan. Thank you for your comments and questions. I do not look for any specific difference in volatility for the back month versus the front month, as long as the front month is higher. When the stock declines both months volatility will increase, as you know. I agree that the back month is less variable than the front month. When I stated you can still make money in this scenario, I realized this is not 100%. I agree it helps to model this in TOS using the analyze tab and clicking the wrench and then more to adjust the front and back month volatility separately. This is a great tool.

    • Hi Neil, I don’t have a set number. My biggest problem with trading is finding the time to scan markets to find setups like this. Like many traders, I have a full time job that limits my time invested. It’s very time consuming scanning for option trades where vol gives me the theoretical edge that I’m looking for.

    • I spent a little time doing analysis on VVUS tonight and came up with the following answer to your question: Not a good candidate. Why?

      At first glance the front month is clearly (ridiculously) elevated as they wait for data on Qnexa to come out. This high IV just asks to be sold, however you mush consider what to spread the risk against. Here is where your problem lies. All back months are elevated IV too. As you know, if you buy a back month option it has a greater exposure to vega than the front month. When IV collapses you simply will lose too much on your long option to make the front month vol crush profit.

      I didn’t spend too much time, but you may be able to construct some kind of ratio spread that is somewhat neutral that takes advantage of the vol crush. If you feel like taking a directional trade a vertical spread will work or keep it simple and buy / sell the underlying and pay up for long options as protection.

      Thanks for the comment/question.

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