Volatility has dropped significantly in the last week, with the VIX once again trading below 16. That is toward the lowest levels that we've seen in the last 12 months.
Most of the trades we've looked at recently like one on Apple will benefit when implied volatility drops or remains low.
When volatility is low, it's a good idea to add some trades that will benefit when implied volatility rises.
One way to find potential trade candidates is to look at the implied volatility percentile of a stock. This measures where the current level of implied volatility sits compared with all readings in the last 12 months.
An implied volatility percentile of 0% means that the current level of implied volatility is the lowest level seen in the last 12 months.
Russell 2000 ETF's Low Volatility
The iShares Russell 2000 ETF is currently showing an implied volatility percentile of 0%. That could mean it's a good time to be a buyer of options in IWM stock.
We can do this via a strategy called a long straddle, which is constructed through buying an at-the-money call and an-at-the-money put.
Buying at-the-money options can be expensive, and they will also suffer from time decay, meaning that they will lose a little bit of value with each day that passes if the stock doesn't make a big move.
With a long straddle, the further out in time the trade is placed, the slower the time decay, but the options are more expensive and require more capital.
I usually go out about three to four months for long straddles and then look to close the trade halfway through if the profit target or stop loss have not been hit. This helps to minimize the time decay, which gets more severe the closer the trade gets to expiration.
Potential Profit, Loss On Russell 2000 Straddle
A long straddle could be placed for the Russell 2000 ETF by buying a January-expiration 227 strike call and put. The call was trading Wednesday around $8.85, and the put around $9.35.
When we add the two together, the total cost of the trade would be around $18.20 per share, or $1,820 per 100-share contract. This is the total amount of risk in the trade, and the maximum that could be lost.
The break-even prices are calculated by taking the strike price plus and minus the cost of the straddle.
That gives us break-even prices of 208.80 and 245.20, but profits can be made with a smaller move if the move comes earlier in the trade.
Implied Volatility Impacts Russell 2000 Trade
For example, the estimated break-even prices at the end of September are 219 and 234.
Changes to implied volatility will significantly impact this trade and the interim breakeven prices, so it's important to have a solid understanding of volatility before placing a trade like this.
The worst-case scenario with this Russell 2000 long straddle would be a stable stock price that would see the call and put slowly lose value each day. For a long straddle, I usually set a stop loss at around 20% of capital at risk, which would be around $365.
I also wouldn't hold this trade for more than three to four weeks.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
