When is the Best Time to Buy Option Premium?

Option traders, today we want to get a little more philosophical than we normally.  As you know, last week I spent much of the time pointing out that several stocks were hitting multi-year implied volatility lows:  GOOG and AAPL to name just a few,.  Even names like the banks and XLF are starting to get 'cheap.'  This led us to the question:  when is the best time to buy option premium?

From a market makers perspective, I would argue that this is a hard question to answer.  Obviously, like all traders, market makers would love to be able to buy the absolute bottom of the barrel in volatility.  However, it tends not to work that way.  Take a look at the chart below from LiveVolPro:

aapl_12.JPG

livevol (r) www.livevol.com

If I didn’t tell you specifically that this is a graph of AAPL option IV, you might think that it was a biotech that had an FDA announcement go against it.  You could easily think that it is a stock price.  A good market maker trades options like it is a stock price.  He or she makes a market AROUND the volatility, not to actually take a position in volatility.  No market maker would choose to put on a big position into AAPL earnings (although they are often forced to).  Basically, market makers try to begin to accumulate options when vols are really cheap and build a position then.  This allows them to sell the options on the way up.  It is how they manage demand.

But what about the retail trader?  Should the retail trader try to pick bottoms and tops in options?  One could make an argument that they should in some of the index products, but in truth, probably not.  The difference between the market maker and the retail trader is the money and margin.  Typically, a market maker can always afford to buy more or sell more of something (when they consistently can’t, that is a sign they are going to blow out someday).  Retail traders do not have that luxury.  They typically get one or may 2 times to pick the bottom or top, and then they are often out of dough.

Thus, I would argue that retail traders should not try to pick bottoms and tops, but actually try to pick the 'hump.'  By this I mean, traders should wait until volatility ticks up off a bottom or down off a top and then jump in.  It can be tempting to try and pick points, but unless you have the ability to go in to a trade 3-5 times and do more, one should not attempt to pick bottoms and tops on straight volatility.

Naked positions should be done on the round, not on the top or the bottom.  Does this also apply to spreads?  Kind of.  I would always argue that spreads give the trader better abilities to initiate a good trade.  We at option pit would much rather see a condor or butterfly sold because the trader perceived the spread as expensive vs. something mechanical like days to expiration.  The former shows domain knowledge; the later shows that a trader can read a calendar.

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