Welcome back to my series on volatility crunch. Last week we defined terms and explained in a general sense why volatility crunch can bite you if you’re tempted to buy cheap, way OTM options on underlyings whose options trade at large implied volatilities.
Today I’d like to start by firming up some general concepts of volatility. Then we’ll discuss some alternate strategies to consider that let you make the same play, while minimizing your susceptibility to an implied volatility crunch.
Good things to know about implied volatility.
Last week in my post I made a small reference to implied volatility being a way to gauge the fear in the market place. I will expand on the concept by talking about the VIX index. The VIX was designed to be a consistent, 30-day benchmark of expected market volatility (implied volatility), as measured by using At-the-Money S&P 500 index (SPX) option prices. Looking at the chart of the VIX index vs the SPX for 2007, it is easy to see when option traders are worried and when they are more comfortable about where the market is going next. You will note that when the market spikes up the VIX spikes down and when the market spikes down the VIX spikes up. In other words, there seems to be an inverse relationship to implied volatility and the direction of the S&P 500 index. It’s important to note that the graphs are not mirror images of each other, but you can see the “general” correlation. This implies a general truth we’ve all observed: the world is more comfortable when the market is going up then when it is declining. It’s also a general belief that stocks have a tendency to go down faster and farther then when they’re going up. The beginning of 2008 has definitely been proof of this.
Puts vs Calls?
I bring this concept up because the short term trader has a tendency to play only the bullish direction of the market. If you truly understand what a change in IV can do to your option, you’re speculating on direction around a news event, and you understood that when stocks or indexes goes down in general implied volatility goes up or at least stays the same, all these facts lead you to this surprising rule-of-thumb: most of the time it’s better to be the buyer of a put contract and be right than the buyer of a call and be correct. Why? Well, odds are, if you buy a put and the market goes down implied volatility will stay the same or increase as opposed to on the call side, where chances are IV will decrease. Don’t forgot: if you’re long an option contract an increase in implied volatility with increase the value of your option, which is good, and a decrease IV also means a decrease in value, which is bad. Now to know what a 1-percentage point decrease or increase will do to the value of your option, look at the vega of the option contract. My series of vega posts (which starts here) can fill you in more on this.
How can you play things differently?
The next time you want to trade options around a news event (like earnings) and the implied volatility of the options are near yearly highs, here are a few other moves you can consider:
1. Buy the stock, if it’s cheap enough. Check out this post on my “just a few bucks” rule of options: if the stock costs less than $10 and you’re bullish on it, you might want to forget buying options and just go long the stock instead. That way, you don’t have to worry about being right before the options expiration or what might happen to the implied volatility of your option contract. Do you really need the leverage that options bring when the stock is trading for such a low dollar amount?
2. Consider buying ITM options with the same amount of capital. If you have, say, $3000 to invest, consider using it to buy 5 ITM options versus picking up a bazillion OTM options cheaply. It’s the same long shot play, but implied volatility CAN NOT affect the intrinsic value of your option. So if the options has 5 dollars worth of intrinsic value it will for sure trade for at least $5. Always check the time value and be aware the IV can mess with that portion of your option. Now if you’re wrong about the direction you will more than likely lose money no matter whether you went ITM or OTM. But with ITM you will very rarely be right about the direction and lose money which can and does happen when buying OTM options.
3. If you still want to trade OTM options try long spreads. A long spread is a combination of a buy and a sell of different strikes on same underlying – same expiration date same number of contracts, same type, either both puts or both calls – differing only in their strike prices. (For more info, check out my series on long spreads, starting here.) If your stock is at 18, consider buying the 20 call and selling the 25 call versus just buying the 22.50 call outright. Since you bought one option at the same time you sold another if implied volatility decreases, hurting the leg you bought, it’ll at least help the leg that you sold. Also the credit received from the sale of the second option can help reduce the cost of the one that you bought. The downside of a long spread is that the profit potential is limited versus the unlimited profit potential of a straight long position; commissions add up more to trade two options versus just one. But if you’re willing to accept the limited upside a spread is a nice trade off to be less concerned about what might happen to implied volatility.
Next topic: LEAPS vs short term.
Next week we’ll talk about LEAPS, or Long-term Equity AnticiPation Securities, can be attractive for longer-term plays, but bear in mind they may be just as susceptible to volatility fluctuations as their shorter term comrades. We’ll address this next week.
Regards,
Brian (Og)
[image: Crunch by Cyron on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
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.
