Volatility is in the stratosphere, and the S&P 500 is likely to be anywhere but here in a month. So why not build a long volatility trade to profit from the instability?

I received this question from one of our team members and wanted to address it with today’s post.

The Long and Short of It

Let’s start with a quick review. Volatility-based trades are also called vega trades, and there are two types.

Long volatility strategies profit if the market moves more than expected in either direction. They are known as bi-directional trades and you can think of them as trades that win if options are too cheap. The following fall under this category: long straddle, long strangle, inverted butterfly, debit condor (or debicon)

Short volatility strategies profit if the market moves less than expected. They are known as neutral trades and you can think of them as trades that win if options are too expensive. They are a bet that options are too cheap. This bucket includes such strategies as short strangles and iron condors.

The Fine Print

The appeal of bi-directional trades right now is obvious. What better time to enter trades that flourish if the market moves a ton than at a time when the market is moving a ton!?

But there’s a small wrinkle that lessens the appeal, at least slightly. It’s incomplete to state that we win on bi-directional trades if the market rises or falls. You have to add three critical words to the end to make it complete. Like so:

We win on bi-directional trades if the market rises or falls more than expected.

A Complete Definition

The million-dollar question when considering bi-directional trades then, is “what is priced-in?” You have to know that before you can make an informed decision on if one of the bi-directional strategies is viable. For example, let’s say you discover that your $100 stock is baking in a $10 move over the next month. That’s a 10% pop or drop. If you believe the stock has the mustard to move more than that – say, $13 to $18 – then entering a bi-directional trade would make sense.

You can look at a few different places to find what the market is pricing in. Know this, though. If implied volatility is really high, then a big move is already anticipated, and bi-directional trades are priced accordingly. If implied volatility is low, then only a small move is anticipated, and bi-directional trades are priced accordingly.

With the VIX still flirting with 60 as I type this, implied volatility is unequivocally high. This is arguably the biggest hurdle to long volatility trades. They could still work, mind you. It just may not be as much as a slam dunk as you first thought.

Expected Move

The amount of movement being priced in is also known as the “expected move.” You can find within the options chain on the far right. Each row corresponds with a different expiration cycle. Because of the relationship between movement and time, you will find the range widens as you move from closer expirations to those that lie in the distance.

Take May SPY options, for instance. With an implied volatility of 55%, the options are baking in a move of +/- $41.87. That’s a lot of movin’ and groovin’! Since it’s a $261 stock, that translates into a move of 16%. In dollar terms, SPY could push up to $302.87 or down to $219.13.

So, if you were to buy a May straddle or strangle or some variation, you would essentially be wagering that SPY would end up moving outside that range.

Of course, that assumes you hold to expiration. If you exit quicker, the range SPY needs to trade outside of shrinks. You can use a risk graph to model the breakevens at varying points in time. By modifying the strikes or trade structure from a strangle to butterfly or condor you can also influence the overall profit range.

Bottom Line

The sharp market volatility makes bi-directional trades intriguing. But that appeal is partially offset by the burdensome prices you have to pay due to the sky-high implied volatility. It can still work, but make sure you analyze what’s already baked into these trades and are comfortable wagering we move more than that.

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