Why do options traders pay so much attention to the underlying’s movements – and ignore volatility entirely? Many traders don’t realize how significantly volatility impacts their positions. This post continues an ongoing series on volatility in options trading, focusing this time on short call spreads.

Welcome back to my series on volatility in options trading. The first post defined 3 key volatility terms: implied versus historical volatility and vega, the Greek measuring volatility’s affect on an option’s price. Post 2, Volatility: When Vega Trumps Delta, illustrated how volatility crunch can prey upon long options, using Google (GOOG) calls and puts as an example.

Let me point this out on the upfront: 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.

Post 3 moved on to long call spreads. Generally considered a neutral-volatility play, once you’ve put on a spread you do need to watch volatility levels closely. (A long call spread consists of buying a call at strike A while simultaneously selling another call at strike B; both calls have the same expiration month. You’re rooting for the stock to trade at or above strike B. Your max potential profit is limited to the difference between Strikes A and B, minus the net debit paid, while your max potential loss is limited to the debit you paid when initiating the trade.) Whether your forecast was right or wrong, implied-volatility should be a factor in choosing your exit point.  

We’re sticking with spreads today, but moving to short call spreads to show how the volatility considerations differ as you manage your exit. (Follow this in detail at Education > The Options Playbook > Play #14, Short Call Spreads.)

As I said before, even with vol-neutral strategies, it can pay to watch volatility levels as you manage your exit from a spread trade. To understand why, ask yourself: which options contract is most affected by an increase or decrease in implied volatility? The answer is the most at-the-money (ATM) option contract for a specific expiration. Because this option is either just in- or out-of-the-money, it has little to no intrinsic value, and is made up mostly of time value. A change in IV can only affect time value, not intrinsic value.

As an option becomes further in- or out-of-the-money, the option’s time value decreases. This makes at-the-money options especially susceptible to IV fluctuations. Keep this in mind as you read on.
 
Imagine our short call spread looks like this:

First Solar (FSLR) is trading at $131.43 on 8/19/09
September options have 30 days remaining until expiration.
Sell 1 Sep 140 call at 5.50
Buy 1 Sep 145 call at 4.00
Net credit = 1.50
Break-even is $140, [TradeKing commissions will amount to $11.20].

You want the stock to trade at or below 140 at expiration, so that both calls expire worthless, and you get to keep as the net credit, your max potential profit. Your max potential loss is limited to the difference between the strikes 5 (145 -140), minus the net credit received $1.50, or 3.50 (less $11.20 commission).
 
(Keep in mind: multiple-leg options strategies, like spreads, involve additional risks and multiple commissions and may result in complex tax treatments. Keep the risk of early assignment in mind when constructing your own trades. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.)

If your bearish-to-neutral forecast is correct and the stock stays below 140, your focus is now on the short 140 call. You want to buy this call back for as little as possible to close the trade. That means you want IV to drop, allowing you to buy back the short 140 leg cheaply, and helping you keep most of the net credit collected when the trade was established.

What if you fall asleep at the wheel, though, and XYZ zooms through 140 and up to 145? Your forecast was incorrect, so your main goal should be to keep the cost to buy back the spread as low as possible. In other words, now you need help from the long 145 strike option. Since this is an ATM option, an increase in IV will increase the value of the long 145 call (good) more then it will increase the value of the short ITM 140 call (bad). Higher IV helps this long call maximize its price, which will keep the cost down on the spread if you choose to close the spread prior to expiration.  

If your trade goes against you and IV starts to climb, you might want to think about just getting out of the trade versus waiting-and-hoping volatility does not decline or that stock will come back. It’s smart to finesse an exit to a losing trade if you can, but not at the risk of potentially losing even more. Sometimes speed is of the essence.

Checking volatility levels at TradeKing

By now you’re hopefully planning on watching implied-volatility levels the next time you put on a spread, short or long. TradeKing makes it easy to watch volatility closely on all your open positions.

The Accounts > Holdings page includes position vega for each position you’re holding. Remember, vega is the Greek measuring volatility’s affect on an option’s price; position vega is the net impact of volatility on a multi-leg position. Negative vega means volatility hurts your position, so you want it to go down. A positive vega number means volatility helps that position, so you’re rooting for it to rise.

Same caveat applies to vega as for IV above: While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility the option contract there is no guarantee that this forecast will be correct.

Quotes + Research > Volatility Charts are another great resource for tracking volatility and its impact on your positions. (Watch this video tutorial to learn more.)

Last but not least, you can use the Profit + Loss Calculator under Tools to track volatility’s impact on your trades, too.

Until next time!


Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

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Brian, what is your experience with volatility of individual stocks? In general higher volatility means lower prices for broad-based indexes like SPX. Is this the case of the individual shares?

I am confused by the statement “In general higher volatility means lower prices for broad-based indexes like SPX”. The larger the implied volatility for both stock and index options the higher the valuation for all the options in the chain will be, but especially the ATM options. 

Regards,
Brian (Og)

Thanks Brian for the great posts on vols!  Most helpful.  

This really becomes important on spreads when you ramp up the contracts and you look at what the vols will do to your positions in both getting in and out of spreads.. Volatility is often equally important as price movement, especially in calender spreads.