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Free Volatility

If I did nothing but buy volatility in instances when my downside is breakeven, I would do it literally 100 times out of 100.

A couple of subscribers asked me why our recent trades in LOW and JOY were a success when we only broke even or made a couple of dollars, so I thought I would address my reasoning with everyone.

As I’ve mentioned, buying options—whether it’s calls or puts—can very easily be compared to buying insurance. When you buy options/volatility, you are essentially protecting yourself from a large move in the underlying stock.

I know I pay quite a bit of money every year in health, homeowners and car insurance to protect my family from the unknown. Notice how I said, I PAY for insurance—that protection’s not free.

Now let’s bring this back to the options world. Recently, the market has been getting volatile again, with 1% moves in the market every day during the past week. Now, I can’t predict how this will play out, whether it will be a crash or a move to all time highs; but the options markets are pricing in sustained volatility.

So when we get “free” volatility for four-day or five-day stretches, I consider the trade a success. If the Japanese stock market had fallen apart this weekend—which certainly could have happened—we would have been thrilled to be holding the JOY straddle.

In conclusion, the insurance comparison is a good way of thinking about volatility. However, insurance only serves to protect you, while options can also enrich you, as there is added opportunity for profits, not just protection.

If I did nothing but buy volatility in instances when my downside is breakeven, I would do it literally 100 times out of 100. Insurance for free is something I can’t pass up. If five out of those 100 times the market or stock makes a large move, we will have bought our profits for free.

On a side note, I am debating a position in Caterpillar (CAT) for later today in which I believe we will be buying volatility for “free.”

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