Option Selling Strategy for Trading Market Bottoms

High volatility associated with stock-market bottoms offers options traders tremendous profit potential if the correct trading setups are deployed. Through a net options selling approach, there is a way around this problem. Here we’ll look at a simple strategy that profits from falling volatility, offers a potential for profit regardless of market direction and requires little up-front capital if used with options on futures.

Finding the Bottom

Trying to pick a bottom is hard enough, even for savvy market technicians.The correct option selling strategy, however, can make trading a market bottom considerably easier. The strategy we’ll examine here has little or no downside risk, thus eliminating the bottom-picking dilemma. This strategy also offers plenty of upside profit potential if the market experiences a solid rally once you are in your trade. By getting short volatility, the strategy offers an additional dimension for profit.

Shorting volatility

The CBOE Volatility Index (VIX) uses the implied volatilities of a wide range of S&P 500 Index options to show the market’s expectation of 30-day volatility. A high VIX means that options have become extremely expensive because of increased expected volatility, which gets priced into options.

When there are high levels of implied volatility, selling options is the preferred strategy because it can leave you short volatility and thus able to profit from an imminent drop in implied volatility. By deploying a selling strategy when implied volatility is at extremes compared to past levels, we can at least attempt to minimize this risk.

Reverse Calendar Spreads

To capture the profit potential created by wild market reversals to the upside and the accompanying collapse in implied volatility from extreme highs, the one strategy that works the best is called a reverse call calendar spread. The strategy of buying the near-term and selling the long-term works best when volatility is very high.

The reverse calendar spread can generate a profit if the underlying makes a huge move in either direction. The risk lies in the possibility of the underlying going nowhere, whereby the short-term option loses time value more quickly than the long-term option, which leads to a widening of the spread.

A reverse calendar spreads offers an excellent low-risk trading setup that has profit potential in both directions. This strategy, however, profits most from a market that is moving fast to the upside associated with collapsing implied volatility. The ideal time for deploying reverse call calendar spreads is, therefore, at or just following stock market capitulation, when huge moves of the underlying often occur rather quickly.

Finally, the strategy requires very little upfront capital, which makes it attractive to traders with smaller accounts.