Over the past several years, options trading has evolved along two basic directions. The first involves structuring trades that are designed to profit from a particular view of the market. In most cases these positions serve as a proxy for stock ownership: they allow an investor to be long or short in a specific time frame with a certain amount of risk.
The second approach is based on trading the underlying mathematics of options pricing theory. Profits can be generated by rising or falling implied volatility, time decay, changes to the implied volatility skew or random movement of the underlying stock above or below a limited price range. Investors who pursue this type of strategy are more focused on trading volatility than direction and their trades tend to deliver consistent profits across a variety of market conditions.
Most approaches to trading volatility focus on a particular mathematical distortion that results in “mispriced” options for a particular timeframe. Weekly short butterflies are an excellent example. This particular trade structure tends to favor stocks that exhibit more movement on a daily basis than their implied volatility suggests. These trades, therefore, profit from price change behavior that is not comprehended by normal options pricing theory. Unlike many other trade structures, short butterflies have a very limited and predictable potential for loss and a precisely defined return, that is, characteristics that allow scaling to meaningful levels that can form the basis of a portfolio.
Jeff Augen
No Relevant Positions
