Over half of 2011 has been characterized by a low implied volatility (IV) environment in virtually all underlying securities. This milieu ended suddenly and abruptly on the recent sell-off that started towards the end of July and IV generally remains significantly elevated above its recent nadir due mostly to the European debt and banking crisis.
An example of the recent rise in IV can be seen in Apple ( AAPL ). This underlying spent most of 2011 with options trading at IV’s of 30 percent or below. Since August, the options have begun trading in the range of an IV of 30 percent and higher–even as high as 52 percent. Since its peak in October, IV has steadily declined to its current level of 32 percent at the time of this writing.
In October at the height of IV, traders need to be on guard and conscious of the fact that volatility could decline and possibly their long option premiums. It is important to recognize that positions characterized by being long volatility (positive vega trades), especially long calls, will likely be negatively impacted by increasing prices since IV is generally inversely related to price.
Option strategists wanting to take a bullish position in AAPL may want to consider trade structures which offset much, if not all of the impact of decreasing IV. In optionspeak, this can be described as reducing the least!
vega of the position. Such strategies could include buying a debit call spread as opposed to a single-legged long call position. This technique is referred to as volatility hedging. More on this in future blog posts.