After a few years trading spot forex, which I still do, I found that focusing on a small number of pairs allowed me to stay more focused and better identify opportunities than watching 40 minor and cross-pairs. Many of the ground rules I follow trading options come from my forex experience and apply just as well.

Liquidity and Slippage

As in forex and equities, when trading options liquidity should be your primary focus, especially trading a smaller account. Suppose you decide to trade options on a stock where the ATM markets are $0.20 wide and you can only get filled at the bid or offer. If you’re trading a credit spread for a $1.00, you’re giving up 20% of your win right off the bat, and for what? Is the opportunity really that much better that you’re willing to give up a fifth of your possible win to play? I doubt it. With a small account, we’re already pretty tied down on capital and can’t afford to give up a single penny on a trade. As such, we will start by narrowing down the hundreds (thousands?) of optionable equities and ETFs down to our Top 10 listed in a previous post. These underlyings have very tight markets and will allow us to get in and out with a minimum amount of slippage.

Volatility Screens

There is a strategy for every volatility environment, and as such the term “screen” for vol measures is kind of a misnomer. First, we will look for high or low implied volatility (IV) relative to itself over the past year, measured in the form of IV percentile. IV percentiles of <30% and >70% will stand out to us as opportunities to buy and sell volatility, respectively. IV percentiles at these extremes show us that implied volatility is much lower (higher) than usual and a possible opportunity to buy (sell) vol.

Second, we will consider IV versus historical, or realized, volatility (HV or RV). Remembering that IV is the volatility implied by options prices determined by the market, if IV grossly overstates or understates the actual (realized) volatility of the underlying, we would expect the two to converge and thus a vol arbitrage opportunity to be present. For example, if IV grossly overstated HV, we might look to sell options and vice versa.

Finally, we will consider volatility skew. If call options on a certain underlying happen to be relatively more expensive than puts, we would look to sell those calls. If puts, on the other hand, appear to be relatively underpriced, we might look to buy volatility on the put side and take advantage of the pricing discrepancy.