Conventional wisdom, when it comes to options trading, leaves the door wide open for us to make enormous profits, due to the general lack of understanding about why stock and index options are used, and by whom. (This topic excludes Commodities options because that’s a different story altogether).
In the beginning, most option traders used the options for directional trading and for hedging against actual long positions in the stock or basket of stocks (index). This is because they could control large positions with a comparatively smaller amount of capital. This led to trading using the options only as a surrogate for the long stock positions. The “market makers” which no longer exist, were able to use the time value premiums and the Vega component of options to price the things to their advantage. They knew that time value premiums and Vega premiums could be manipulated to obscure the true value of the options. This is what today is perceived as the Bid – Ask spread or natural price.
So, over time, some traders realized they could use the time value and the implied volatility additive to sell the options and benefit from the markets staying with a normal or bell shaped curve. In other words, standard deviations of price and velocity.
The selling of options for profit and strategy began to take hold and was like the wild west where the ignorant strolled into town and barely go out alive …or worse.
Then, fast forward to our recent time period, most retail traders attempt to earn money from the time decay of options. This, of course is fine, as long as the positions are managed for the inevitable under pricing of options and the 2-3 standard deviation moves. This is where the impact of implied volatility tilts the scales toward the option buyer vs. the option seller.
A trader cannot consistently operate without the knowledge of low implied volatility leading to higher volatility. Single strategic tactics will not provide the depth and flexibility to navigate the markets as they move from low to high volatility.
That’s one reason that today the key to trading option positions thru changing environments entails the use of combining tactics that compliment the environment. Using the least number of options contracts to protect and govern the position is the way we trade as professionals. Borrowing from the ancient aliens that traded long options in the beginning, we now have tactics where we can buy long options when the IV is low and incorporate them into our overall positions. In keeping with our aliens theme, we can view these long options as drones of sort, sent out to protect the mothership. They are sometimes may run out of gas and become expendable if no attack to the main position occurs. But most of the time the long options do their job efficiently and we return them home with a heroes welcome in the for of profits to our position.
(for more on this topic see the recorded course “Options Combinations Strategies)