One of the most important parts of my process in selecting potential options trades is to assess the current volatility situation. Everything else being equal, I like to put on trades that position myself for volatility to revert to its mean. In other words, if volatility is high and therefore options prices are high, I want to express my directional trade in such a way that it might also benefit from volatility falling back to “normal” levels. Conversely, when volatility is low, I want any position I consider to benefit from a rise in volatility — if there is one.
There are no free lunches on Wall Street, nor in options trading. But betting on volatility reverting to the mean might be one of the closest things to it. The trick is in the timing.
Of all the most liquid ETFs I track, the one that has been the quietest lately — in terms of price action and volatility in options pricing — is the Retail Sector ETF $XRT. In fact, volatility in $XRT is currently at the lowest levels last seen in 2018 before the Christmas selloff. This has given me a wild idea…
I’ll spare you the boredom of a daily chart. Trust me when I tell you the sector ETF has been trading virtually sideways in a dollar-and-a-half range since the 2nd week of January.
But I will draw your attention to this much more interesting plotting of volatility pricing in $XRT for the past year:
Here you can see what I mean about vol being at the lowest levels of the past year. Of course, volatility could very well continue to remain low for quite some time. Not ideal, but we can rest comfortably knowing it is unlikely to go much lower from here, offering some price stability in any longer-term long options we might purchase.
Now, call me a contrarian if you like, but I don’t see the retail sector staying quiet for too much longer. And with options prices so low, we can afford to take a shot in long options dated out to October — giving us a lot of time for literally anything to happen to bring some juice back into these options. Additionally, these currently cheap options give us the opportunity to affordably play for a breakout in either direction!
Here’s the Play:
We’ll be buying an October 45 Straddle for approximately $5.25. This is a delta neutral trade which gets us long both Oct 45 calls and an equal amount of Oct 45 puts. Our risk is defined to the debit we will pay at entry and will only be suffered in the unlikely event $XRT were to close on October Expiration day precisely at the 45 strike. But we won’t stick around for that eventuality because once the calendar turns to October, if the value of our position is less than the price we paid to enter (we’re losing money), we’ll close it down in the first few days of October and take our loss. What’s left of the premiums in those long options will begin to rapidly decay away as we approach the October 18th Friday expiration day.
If, however, we’ve put ourselves in a great position to get lucky on a $XRT breakout move in either direction — we’ll look to close half of our position if/when we get a double in the value of the position. So, for example, if we buy 10 contracts (10 calls + 10 puts) for a net debit of $5.25, we’ll sell 5 contracts (both calls & puts) for a net credit of $10.50. This removes all of our original risk capital from the trade and gives us a free ride on the rest. And once we get in to October we’ll then use any nearby support or resistance levels in which to key off for our exit and book our profit.
The beauty is, we’ve got until October expiration — plenty of time — for any move to materialize. I like our odds.
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