pinball.jpgHello, folks. I wanted to follow up my recent post on volatility skew by touching on another skewing in volatility called “volatility tilt”. Understanding this concept can help both options AND equity traders plan for big potential swings signaled by upcoming news.

Ask the Audience

On the trivia show Who Wants to be a Millionaire, you’ve seen how the contestant who’s really in a pickle often relies on the most popular lifeline, “Ask the Audience”. More often than not, it seems, the audience is surprisingly right.

The options market is actually pretty similar: you can tap the collective wisdom of options traders by watching the implied volatilities (IV) of the different expiration months before taking the plunge on placing trades. (TradeKing’s Options Chains tool makes it this easy.) Just scanning the IV of at-the-money (ATM) options for large differences or skews in the numbers can tip you off to pending news. It can also be a hint that you should dig a little deeper to find out what might be happening in the short-term.

An example: Priceline.com (PCLN) earnings

This scenario pops up fairly frequently when the underlying company is about to announce earnings. Let’s take Priceline.com (PCLN) as an example; they announced earnings not too long ago.  Below is a table of ATM IVs of Priceline options five days prior to the earnings announcement.

priceline_earnings.png

Notice the nearest-term February calls are trading a full 35% (110% - 75%) higher than the next expiration month out, March. This means the marketplace is implying a large possible price move before the February expiration date. Don’t forget that implied volatility does not have any regard to direction - it just means that there’s “something” pending on the horizon that could move the underlying stock price quite a bit up OR down in the near term. This did prove to be the case for PCLN: the earnings report after the close on 2/14/08 actually caused the stock to open up almost 9 points the next morning.

Another example: IBM

Now let’s look at volatility tilt on a stock without major pending news in the near future. Consider IBM on the same day (2/09/08) in the previous example. Its February ATM call was trading with an implied volatility of 33% and the March ATM call was at 32% - this is classified as more “normal” volatility tilt. This doesn’t mean that major news might not surprise the market, but it does imply that there’s no pending news on IBM that the market is aware of.

Volatility tilt can crop up in many scenarios involving pending news: earnings season, phase-2 drug trials for pharmaceutical companies, pending court cases over patents - whatever known news that might occur before the expiration of the front month.

A quick scan of IVs for signs of volatility tilt can help you avoid getting squeezed by a news stampede – or help you locate volatility waves you’re interested in riding. Either way, it’s always best to pick up on these signals early if you can, so you can plan accordingly.

Regards,
Brian (OG)

[image: Earthshaker Pinball Machine-4 by robinvanmourik 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.