Exploit Elevated Volatility With This S&P 500 Option Trade

The problems stemming from the Eurozone continue to hang ominously over the global stock market.

While October saw a groundswell of buying that bolstered equity prices and returned us to more of a normal trending state, Wednesday�s market sell-off was a painful reminder that we�re not out of the woods yet.

Not surprisingly, the bloodbath was accompanied by a notable surge in panic as demand for option protection soared. The CBOE Volatility Index (CBOE:VIX) rose an impressive 31.5%, vaulting from 27 to 36. The last two times the VIX reached these heights, the advance was rebuffed — signaling a golden opportunity to enter short volatility plays. Such an opportunity may be in the cards yet again.

The common play of choice for traders looking to exploit elevated option premiums is the iron condor. Though it is a four-legged position and perhaps a bit intimidating at first glance, it�s actually a fairly straightforward strategy.

Think of it as exactly what it is: two spread trades on the same underlying asset. Best of all, both of them pay you right away!

An iron condor involves simultaneously entering an out-of-the-money bull-put spread and an out-of-the-money bear-call spread. The strategy is designed to profit as long as the market remains between the short strikes of either spread.

With implied volatility as high as it is, the options market is pricing in huge movement over the coming month. By entering an iron condor, we�re expressing our opinion that the market will NOT move as much as is currently priced in.

With the SPDR S&P 500 ETF (NYSE:SPY) currently trading at $124, we could enter an iron condor by selling the following two spreads:

1. December Bear-Call Spread: Sell to open the SPY Dec 133 Call for $0.70 while buying to open the SPY Dec 138 Call for $0.14. The net credit received on this part of the trade is $0.56.

2. December Bull-Put Spread: Sell to open the SPY Dec 110 Put for $1.47 while buying to open the SPY Dec 105 Put for $0.97. The net credit received on this part of the trade is $0.50.

The total credit received for the iron condor is $1.06 ($0.56 + $0.50), which represents the maximum potential reward. The max risk is the width of the spread ($138 strike – $133 strike, or $110 strike – $105 strike = $5) minus the net credit ($5 – $1.06 = $3.94).

Provided the SPY remains between $133 and $110 by December expiration, the iron condor will come out a winner. This means the SPY would have to rise more than 9% or fall more than 11% in about five weeks for the trade to be a loser at expiration.

Source: MachTrader

At the time of this writing Tyler Craig had no positions in SPY.