volatility crunch: part 1

Here’s a scenario I hear a lot around earnings season, or in volatile sectors generally: you spot a cheap OTM option with a few weeks of life left on a relatively low-priced stock and decide, hey: maybe I could do something with the volatility on that. Sound familiar? Today I want to provide a little perspective on this thinking, so you can avoid what’s known in the industry as a volatility crunch.

If we’re looking for an especially volatile sector that’s tempting many investors right now, we don’t need to look much further than financial services. The sector is extremely volatile because of the sub-prime mortgage mess. Consider Washington Mutual or WAMU (Symbol WM) as an example. This stock is getting hit hard right now by the sub-prime and credit woes, and the February ATM option is trading at a 95% implied volatility. That’s compared to historical and implied volatility a year ago down around 11-12%. I’m not implying that any one should buy or sell this stock; but MU fits the description of a volatile stock that might lure you into a volatility crunch.

Say you’re interested in speculating on MU’s bottom. Now because of the increased implied volatility, you might be tempted to go further out of the money when buying long calls so the contracts are cheap enough to load up a bit on them.  Let’s imagine that, with the stock at 14.20, we bought the February 17.50 strike contract with 32 days remaining to expiration. That contract costs us 50 cents – a real bargain, right?

Ask yourself: what PERCENTAGE gain are you asking the stock to make?

Let’s consider this from a new light. On a percentage basis, a 3.30 cent point move up a $14.20 stock is 23%. That’s a huge move in just 32 days, even for a volatile stock. In other words, that 17.50 call is cheap for a reason: because the probability of the stock hitting the strike price in the next month is pretty low.

Say the stock two weeks later bumps up 2 points on a news headline, a very respectable move in the right direction for your trade. Problem is, for some reason your options isn’t budging at all in response. If you got the move right, why aren’t you making any money? Simple: That 50-cent cheapo price reflected the very, very low probability that your stock would move up to 17.50 before expiration, and probability in this case proved correct: the stock is only now at 16.20, not 17.50. It would still take a 7% move to get to the strike and now there is only a few days remaining to expiration. After the news implied volatility in the options will tend to dissipate, especially if the market is more comfortable with the new stock price. (In the options market implied volatility tends to equate to fear.)

The news has passed, and with it the action in terms of volatility spikes. Its chances now of moving another 8% are close to nil – so unfortunately, you’ve just wasted 50 cents on that long-shot call that probably won’t stage any comebacks. That’s called getting caught in a volatility crunch.  

Bottom line, for this scenario were to end happily for you, you need the stock to basically make the entire 23% move before expiration. Now with that said, it’s not impossible for a move like this to happen, and if it did, you’d look like a genius. Not impossible, but extremely unlikely.  Why cross your fingers for a miracle when you can assess the odds before placing the trade? As you consider this move before making it, ask yourself: what you are asking the stock to do for you on a percentage basis? Does such a move seem likely to happen before expiration? If the answer is no then don’t buy that option; try something different. There’s plenty of money to be made in reasonable speculation – let those wing-and-a-prayer trades go.

Prices, IV, and probabilities: all in tandem

This brings me back to a topic I explored in this blog not too long ago: the tight interrelationship between options prices, implied volatility, and probabilities of success. (Check out the theory in my previous blog post.) Put simply, these three factors move in tandem, so one will never really get too far out of whack before bringing the other two factors back into relationship with it.

Here’s a metaphor that may help: think of options like an insurance policy on your house. How much would you pay for that coverage on your house in Florida, with a hurricane brewing in the distance? Probably quite a lot.

News or earnings on stocks can work like that hurricane: they represent uncertainty on the horizon that could damage your portfolio. That uncertainty can drive up options prices, as investors use options as hedges on existing positions or for more speculative plays. If uncertainty around a particular stock is really high, that’s going to translate into higher-than-normal IV levels and higher prices. When all the news is out, though, prices and volatility levels will tend to drop, since the uncertainty has passed and you’ve “weathered” the storm. Make sure your options can weather the storm, too.

Next week: how could you play this differently?

Next week’s post will suggest a few alternate plays that may prove more effective. We’ll also get into a critical question: if 23% (in our example above) was just too huge of a percentage move to expect, what number would’ve been more reasonable? The answer goes back to this interrelationship between prices, volatility and probability of success. Assessing the probability of your trade before you make it is a crucial step towards more consistent profit-making and less wild gun-slinging.  

Until next week, then!

Regards,
Brian (OG)

[image: Cap’n Crunch by The G-Tastic 7 on flickr]


While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. 

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.