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The Crushing Effect of Implied Volatility & How to Profit From It!

Options Sage submits:

As part of Wednesday’s Wrap-Up Phil summarized the outcome of last week’s educational play on BOBJ.   For those of you that might have missed the commentary, I have included it below.  If you’ve already read it feel free to skip to main topic of this week’s article – implied volatility (which had a big effect on the week’s educational play!) – where we’ll discuss why implied volatility is so important and what not to ignore!

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Our educational play of BOBJ had earnings today and it turns out to be a great example of why I don’t like open calls (or puts) into earnings!

The earnings were just what I expected, good but not so great as to make the stock run away.  After a nasty dip, the stock recovered to flatline at $38.71, just 1 penny higher than when we looked at it on Monday morning.

The 4 March $40 contracts that were discussed but not recommended were a $660 investment and held their value yesterday but dropped to $420 today ($1.05 each), losing 33% of their value as soon as earnings went past.  The trade could have been gotten out of for $1.35 for the first half hour of trading, which would have recovered $540 of the investment.

Was this better than having taken $4,000 to buy shares of BOBJ?  So far, no.  If you held the shares through the dip to $37.82 in the morning (just 2.5%) you would be essentially even now.  Remember, our goal here is to make $400…

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Phil mentioned that the March 40 contracts lost 33% of their value as soon as earnings passed, despite the fact that the stock recovered to a price of $0.01 higher than where we looked at it Monday morning following a nasty dip.  How is that possible?  How could the option value drop so significantly after the stock ended up flat? The answer lies in the change in implied volatility!

Before we look at a chart, let’s first note that implied volatility represents an ESTIMATE of volatility in a security’s price.  When implied volatility is high, option prices are expensive and factor in an expectation for considerable movement in the underlying stock.  When implied volatility is low, the expectation for significant stock movement is low.

Conventional wisdom suggests that high implied volatility often accompanies bearish markets (though this is not always the case).  The prevalent view originates from the fact that bearish markets often cause precipitous price changes as panic sets in while bullish trends are considered less volatile as investor’s climb the “wall of worry”. 

Just take a look at the VIX right now to note the effect of a bullish market on the volatility index!  In fact, it was so low this week that Phil & co. looked at initiating a nice diagonal spread to that might take advantage of a future spike in volatility while benefiting from time decay in the interim (we plan on discussing these diagonal spreads more in the future).

Leading up to an earnings announcement, uncertainty as to the future direction of the stock price is at a peak.  The direction of the stock following the event can be highly unpredictable; this has been demonstrated repeatedly over the past earnings season (earnings season is often considered to begin with Alcoa’s earnings while Cisco’s earnings signals the end of the season – in practice many companies report before and after each).  Many companies that have reported stellar earnings (GOOG & AAPL spring to mind) have been punished. 

This can be demoralizing if we were to enter earnings without hedging, but we know better than that!  We know stocks can move against initial expectations and hedge accordingly.  Since uncertainty is at a peak prior to earnings and stock volatility is often expected subsequent to the earnings announcement, option prices are relatively expensive beforehand due to the increase in implied volatility.

Once the earnings report has passed the implied volatility tends to decrease substantially as the direction of the stock is now known. Just take a look at what happened to implied volatility on BOBJ options following earnings.

Volatility chart

Chart courtesty of www.ivolatility.com

The yellow line representing implied volatility drops dramatically.  This phenomenon is often referred to as implied volatility crush.

How can we take advantage of this implied volatility crush?  Just like Phil sought to do!

In the weekly wrap-up Phil reviewed the play we did make on BOBJ, a diagonal spread:

This became a good lesson in how a spread can be better than a call as the BOBJ March $40s that were (in the example) bought for $660 finished the flat week at $460 but our recommended spread of the April $40s and Feb $40s for a net of $460 finished the week at $600 (up 30%).  It’s not sexy, but it sure beats a 30% loss on the open call and it’s also better than tying up $4,000 and sweating out the trade…"

Since shorter term options will be affected most significantly by increases and subsequent decreases in implied volatility before and after earnings respectively while longer term options will be impacted to a much lower degree, we can purchase longer term options whose values are not hugely inflated while simultaneously selling shorter term options that have inflated premiums.  Following the earnings announcement we know that the shorter term options will suffer from implied volatility crush to a much greater extent than the longer term options and so we can profit assuming the stock does not move dramatically to counter the benefit of implied volatility crush on the shorter term options.

For this week’s example, Phil has chosen a tight diagonal spread of purchasing the SHLD June $185s for $12 and selling the March $180s for $8.20 or better.  Exact timing of this play will be, as usual, transmitted during the trading day to members but this entry should serve anyone well who keeps the net spread under $4.

Next week we will return back to our options trading instruments and describe a better way to take advantage of stock declines than shorting! 

Have a great week trading!

Options Sage

 


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    Sign up today for an exclusive discount along with our 30-day GUARANTEE — Love us or leave, with your money back! Click here to become a part of our growing community and learn how to stop gambling with your investments. We will teach you to BE THE HOUSE — Not the Gambler!

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  1. Turtle

    Great info on IV …thanks

  2. Options Sage

    You’re very welcome Turtle, glad this educational segment is proving useful!

  3. Mrs. Wolfson

    Me too, new to options and helped me a great deal! Thanks!

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