Doc Maher breaks it down.
Kanchana,
You posted a question on my last post about using Implied Volatility as a strategy. Being an "Income Trader" most of the strategies I employ are based on capturing IV and or time. So this is a question that I'm happy to address. However the subject is very large and the strategies for capturing IV are generally complicated so I can only start the discussion here. The rest will have to wait for other blog entries.
The easy answer is to buy low and sell high or sell high and buy low. But it doesn't tell the whole story. We are tempted to think that if we were to buy a Call when the IV was low that if the IV was to increase that the price of our Call would go up even if the stock didn't move up. And since the IV often moves up before earnings this may sound like a good strategy. However the price of a Call or a Put is affected by three things and IV is just one of them, the other two are time and stock movement.
So our Call could lose money even if the IV goes up if the stock moves down or if enough time passes. Remember that IV is only relative price and not absolute price.
An example will help. I have no positions in GOOG and it's going into earnings tonight 4/17 so let's use it. GOOG closed at $449.54 so a 450 Call is just about at the money. A May GOOG 450 Call cost approximately $26 at the close and that corresponds to an IV of 49.58. This can be seen from the Profit and Loss chart below.
Click here for a larger image (GOOG #1)
If we increase the IV by moving the bar to +15% the P&L is showing a profit of $743, see below. This would correspond to a price of $26 + $7.43 = $33.43 or a gain of 28.6% with out the stock even moving.
Click here for a larger image (GOOG #2)
However this all has assumed that no time has passed. If we look at what happens when there is only 18 days left instead of 30 we can see that we have lost all the gain, again without the stock moving and the IV still at +15, see below.
Click here for a larger image (GOOG #3)
Of course if GOOG had moved down in price we can see that the option would have lost even more. So even in an increasing IV situation you still have time working against you. The reason that I say that the relative price has gone up is that while the option price is basically the same, 12 days have gone by and GOOG is still at $449.54. For what we are getting, that is how much time we are buying now only 18 days, we are paying the same as when the IV was 15 points less and there was 30 days left to expiration.
OK so increasing IV helps but it doesn't guarantee a profit because time and stock movement can over power it. So most strategies that try to capture IV are designed to be less sensitive to stock movement and or time decay.
Strategies that are not sensitive to stock movement are called "Delta Neutral". Delta neutral strategies don't care if the stock goes up or down. Examples of this are the straddle and strangle strategies. In these strategies a Call and a Put are bought. If the stock goes up the Call gains and the Put loses. If the stock moves down the Put gains and the Call loses. So the net is that we don't care if the stock goes up or down. A GOOG P&L is shown below using a May 450 Call and Put.
Click here for a larger image (GOOG #4)
This looks great! No losing positions! Of course this is for today's IV and for today in time (no time passed yet). However the concept of delta neutral is illustrated because this strategy works on stock movement up or down and it doesn't care which it gets.
Now if the IV moves up what happens?
Click here for a larger image (GOOG #5)
Now the P&L is showing a profit of $1,466 with no stock movement and even bigger profit if the stock moves. All this is due to the IV move of 15 points. If we were able to do this in a real trade this would be an example of capturing Implied Volatility. However as we will see tomorrow this is probably not going to work out the way we hoped and I'll show you that next time.
This is only the beginning of the discussion on how to profit from changes in IV. Look for more on this later and in other blog entries.
I hope this beginning helps,
"Income Trader"
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Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
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.
Jonathan F. Maher, PhD. has a professional business relationship with TradeKing.
