Option
Volatility Crush.
Trading
option volatility movement is a fantastic way to receive a short time profit
from a strategy. Earnings play is particular targeted for this style of
trading. The benefit of trading over earnings is that option volatility increases
substantially. If a trader sells premium shortly before the news event the theory
is that the volatility will come back to mean. This movement creates opportunities,
but is not without its risk.
Basically
we are looking to take advantage of current high implied volatility compared to
historical implied volatility.
The point
of a news event is that something may happen and you do not know what the
outcome is or will be. This unknown creates the volatility event that we are
looking to capitalize on. At this stage because volatility is so high we are
going to look at shorting premium. There are many ways of doing this, but we
are just going to cover the event from a selling put perspective, as our
outcome is that the company has a long history of solid performance and we
expect for this to continue.
We are
selling option premium, because if we buy options and volatility contracts as
per what we expect we will lose money on the option. But selling options as the
volatility contracts we can bank profits overnight.
Here are a
couple of examples.
Note: It is
important to only trade in highly liquid underlying, otherwise the bid/ask
price may be too wide and hence the profits will deteriorate just on the
spread. It will also give opportunities to enter and exit at ease.
Stock example
1
The stock
was trading at $46.15. The day of earnings the short term options where trading
at 127% volatility and the next month’s options were trading at 43% volatility.
If we look at a 1 std deviation put option with a strike price of 40 the
premium received is about 46.
The day
after earnings the Volatility went back to 73 % the share price moved to 52.99
and the premium went to 0.05
Here is
what the crush looked like using Interactive broker’s volatility lab;
Stock Code 2
The stock
was trading at $58.25. The day of earnings the short term options where trading
at 105% volatility and the next month’s options were trading at 51% volatility.
If we look at a 1 std deviation put option with a strike price of 53 the
premium received is 44.
The day
after earnings the Volatility went back to 59% and the premium went to 0.13
Here is
what the crush looked like using Interactive broker’s volatility lab;
Here is what the crush looked like using Interactive broker’s volatility lab;
Stock Code 3
The 3rd
stock is trading at $77.97 . The day
of earnings the short term options where trading at 80% volatility and the next
month’s options were trading at 26% volatility. If we look at a 1 std deviation
put option with a strike price of 72.5 the premium received is Bid at 0.17.
The day
after earnings the Volatility went back to 44% the share price moved to 78.30
and the premium went to 0.02
Here is what the crush looked like using Interactive broker’s volatility lab;
From these
three simple examples we can quickly see the opportunities that lay in this
style of trading if managed and done correctly.
Whilst the
figures provided are as accurate as possible from the option bid/ask order
screen there will be variances in data as prices leading up to these events can
move rapidly, and the prices discussed here are probably not the best nor the
worst. They are just what they are at the time of looking at the bid/ask for
this article.
As with any
style of trading, if you are looking to own the shares anyway, this strategy
can be a good strategy to enhance your returns and if exercised you want to own
the stock anyway. But for a pure options play, a trader needs to remember that
if the news event is not in the traders favor, the share price will move
against you and could move to a price that makes the volatility reduction value
less than the share price movement and hence turn it into a losing position.
The Take
Away;
Events which cause volatility to increase a significant amount above its mean, are
a good time to get short premium in stocks. If you wish to own and buy into the stock, the
extra premium will help enhance profits. If you are an option trader using earnings
play and shorting premium, it can help increase profits, if the share price
does not move much, and when you expect volatility to come back to its mean.
If you’re
an options trader remember to trade small. It’s all about occurrences and
managing your profits. The more occurrences a trader makes, the more stable
your return will be from this strategy over the long term. When there is a
profit on the table look at taking it at the earliest possible time, as the the trade is all about volatility contraction not how long you hold a option for.
