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December 15, 2011

Implied Volatility and Historical Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 10:09 am

One of the most important steps in any option trade is to analyze implied volatility and historical volatility. This is the way option traders can gain edge in their trades. But analyzing implied volatility and historical volatility is often an overlooked step making some trades losers from the get-go.

Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of a stock with another stock or to the stock itself over a period of time. For example, a stock that has a 15 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 now is more volatile than it was when its historical volatility was, say, 20.

In contrast to historical volatility, which looks at actual asset prices in the past, implied volatility (IV) looks ahead. Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock’s options. For example, the market (collectively) expects a stock that has a 15 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile.

Analyzing Volatility
Implied volatility and historical volatility is studied using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful visual aide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are  misinterpreted by novice traders.

Volatility chart practitioners need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” price. In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.

But that is not the end of the story. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sale; if it is below its normal level it may be a good buy.

Lastly, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was typically in the past, the stock is now more volatile than normal.

If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can capitalize on the disparity by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.

The Art and Science of Implied Volatility and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are shown here. But there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is unique. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade.

Edited by

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 3, 2011

Juicing Volatility in Apple (AAPL)

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 10:27 am

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 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.

September 29, 2011

Risk:Reward Is Not Static

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 10:47 am

Several groups of option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or failure of movement in price of the underlying.  Examples of such strategies include naked option sales and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three primal forces, the initial risk:reward calculus often changes dramatically.  The successful option trader needs to be aware of these changes, because the risk to extract the last bit of potential profit is often dramatically out of proportion to the magnitude of the profit he seeks to capture.

Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller.  This trader has chosen to write out-of-the-money puts, the October $90 strike, on XYZ which currently trades at $100.  His risk in the trade is that he is obligated to buy XYZ at the strike price at any time between opening the trade and October expiration.  For taking the risk of writing these puts, his account receives a credit of $1 and margin is encumbered based on SEC rules.  The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.

As October expiration approaches, the stock remains at the $100 level and the market price of the puts he has sold decreases as a result of time (theta) decay.  As the price of the puts decreases and the profits increase, the risk:reward increases.  As the price declines below the often used 20% re-evaluation benchmark of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial and may no longer be appropriate given the reward.

The experienced option trader in such trades often finds the opportunities to deploy capital in other trades to be much more attractive than to remain in the existing position.

August 31, 2011

The Two Faces of Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 2:32 pm

In Roman mythology the god of beginnings and endings, Janus, is typically portrayed having two heads, each facing in opposite directions. His countenances are displayed in this manner so that he can observe the past as well as the future.  The two types of option volatility, historical volatility and implied volatility, also reflect this dual perspective.

Historical volatility, also termed statistical volatility by some writers, is a simple mathematical calculation of the demonstrated volatility over various periods of time, hence the name historical volatility. While the precise method of calculation of historical volatility can be argued endlessly, it represents an objective and reproducible measurement that requires only the input of the variable of price movement.

Implied volatility is to be distinguished from the mechanical precision of historical volatility.  Implied volatility is the nexus point at which the raw emotions of the human brain so evident in trading meet the mathematical precision of the historical volatility. Of the three primal forces impacting option price, implied volatility is the only factor subject to cerebration. As a malleable and subjective input factor, it is reflective of both general market sentiment and the subjective evaluation of potential future volatility and direction of the specific underlying. As such, it is a forward-looking evaluation as opposed to historical volatility which is well, historic.

While this distinction may seem arcane and of academic interest only, it is decidedly not. Failure to consider the current position of implied volatility will routinely negatively impact trades and is the most frequent cause of paradoxical behavior of option prices.

August 25, 2011

Interesting and Volatile Times

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 10:18 am

“May you live in interesting times” is an ancient Chinese curse.  The fact that the last few weeks have seen neck snapping and wild changes in volatility, I think we qualify for living in what these philosophers would consider to be interesting times.

For those who are unfamiliar with the impact of volatility on option trades, suffice it to say that the current market contains unique challenges. As I write, the volatility environment has experienced remarkable volatility. While the concept of the volatility of the volatility may seem arcane, it has huge impact on the behavior of option positions.

Remember that option premium, while quoted as a single bid/ask spread, in reality consists of the sum of the extrinsic and intrinsic premiums.  While the intrinsic premium may vary wildly in such markets as we currently are experiencing, it is a straightforward and transparent calculation depending solely on the current market price of the underlying and the strike price under consideration.

The extrinsic premium is not so straightforward and is impacted by several factors, the most important of which are the time to expiration and the IV.  The time to expiration is clearly defined by anyone with a calendar, or perhaps a stopwatch currently, and represents another transparent variable.

The situation is much more interesting in the world of IV.  This is where current unprecedented directional movements impact option prices most dramatically.  The situation is rendered even more complex by the fact that the IV changes are occurring in both directions; it is not simply a trending volatility environment.  The volatility of the volatility has increased dramatically.

Traders must be cautious when establishing new positions and monitor the vega of the position assiduously. In many cases, structured positions such as vertical spreads are indicated in order to reduce vega exposure.

July 26, 2011

Back to Basics: Part II

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 3:27 pm

Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are conversant with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but suffice it to say it is one of the three pricing factors and probably the most familiar to traders.

The price influence, time, is easily understood; in part because it is the only one of the forces restricted to unidirectional movement. The core reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third price influence is perhaps the most important. It is without question the most neglected and overlooked component: implied volatility. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can wax and wane as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should direct their attention to understanding the impact of each of these options pricing influences. The options markets are ruthlessly unforgiving to those who choose to ignore the impact of the valuation metrics that underpin daily life in their world.

June 16, 2011

All In The Family

Filed under: Options Education — Tags: , , — Dan Passarelli @ 9:29 am

For the new options trader one of the most overwhelming concepts is the wide variety of choices of trade structures available in the new world into which he has entered.   The world of stock trading is defined by only two initial choices when considering a trade: short or long. The world of options has many more choices when initiating a trade and each option trade is most profitably defined not only in terms of price but also implied volatility and time.While description of each and every type of option trade is well beyond the scope of a brief discussion such as this, it is helpful to focus on the various families of option trades in order to begin to become familiar with the unique characteristics of each member. One of the most frequently discussed types of trades can be described as those that are profitable over a wide range of prices of the underlying. This group of trades finds its basic family identity in the shape of the P/L curve as well as in the signature family blood type of theta positive.As in any diverse family, there is a wide variety of individual characteristics. The names of the individual strategies within this family is numerous, often duplicative, and frequently confusing. One subgroup of these range bound strategies is flamboyantly named as winged beasts: condor, iron condor, butterfly, iron butterfly, and split strike butterfly. Another less colorfully named branch of the family is that of the double calendar and double diagonal. The structure of each of these trades has a characteristic skeletal framework, but within these defining limits, the latitude in fine structural details is broad.

March 25, 2011

There’s a Time for Everything: Thoughts on Options Strategies

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 4:56 pm

Do you know how many different types of options strategies there are? A lot: That’s how many! But that’s not really the important question. More importantly: Do you know why there are so many different types of options strategies? Now we have something to discuss.

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish traders. Traders who are extremely bullish get more bang for their buck buying short-term out-of-the-money calls. Less bullish traders my buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high and the trader is bullish just to a point, the trader might sell a bull put spread, and so on.

The differences in options strategies, no matter how apparently subtle, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position and, in turn, structure a position that addresses each nuance. Traders need to consider the following criteria:

  • Directional bias
  • Degree of bullishness or bearishness
  • Conviction
  • Time horizon
  • Risk/reward
  • Implied volatility
  • Bid-ask spreads
  • Commissions
  • And more

Carefully selecting options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners, or taking losses bigger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. Be sure to spend time optimizing your options strategies over the next few weeks to build the habit.

March 12, 2011

Maximizing Fade Plays

Filed under: Uncategorized — Tags: , , , , , , , , , , , , — Dan Passarelli @ 9:50 am

Do you feel like you’ve seen this movie before? Trouble in the Middle East. People in the streets; panic in the market. Is this recent wave of trouble going to last forever? Not likely. Perhaps there is an opportunity to fade this fall. But how should an option trader play the fade to maximize chances of success and maximize option-trading returns?

The obvious starting point for a trader to fade this fall is to take a positive-delta position. This is fancy options speak for a bullish trade. There are lots of different ways to take a bullish stance given all the various types of option-trading strategies out there. So, the question really is: Which is best?

There are a few major considerations here. First, traders must strive to maximize reward by minimizing risk. In order to do so, option traders must define their expectations. Am I looking for an extreme turn around? A mild retracement? A dead-cat bounce? The more a strategy can be tailored to expectations, the more risk can be controlled and reward can be maximized.

Next traders need to consider implied volatility. This is where option traders can get an edge in their options positions. If implied volatility is high (overpriced), option traders should consider option-selling strategies. If implied volatility is low (underpriced), option traders should consider option-buying strategies.

In the current market scenario we have a situation where if the turmoil in the Middle East subsides, the market should rally somewhat, but it’s not likely to go to the moon. Further, with the VIX at its current nose-bleed levels and implied volatility of individual stocks following suit, it’s easy to find overpriced options. Any clever fader trader should be looking for put credit spreads to sell. Put credit spreads have positive delta and take a short position on implied volatility. Great candidates for this sort of play are indexes and ETFs like SPX, SPY, DJX, DIA, et. al. Traders are best off staying away from oil stocks and precious metals that might be adversely affected by Middle East stability.

November 2, 2010

Reading Tea Leaves

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 8:24 am

It is often a daunting task deciphering the tremendous amount of information contained within an option chain for the trader beginning his study of the world of options.  One of the most nuanced variables embedded within the prices quoted for the chains is that of the relative values of implied volatility (IV) amongst the various strike prices and the various months of expiration.

The IV of each of the various available options for a given underlying is not usually constant for each individual strike price and expiration cycle.  The IV can and often does vary between individual strike prices within the same cycle; this variation is termed vertical skew.  In addition, IV often varies at the same exact strike price when considered between various expiration cycles; this variation is termed a horizontal skew.

To review briefly, remember that option prices depend largely on the three primal forces of time to expiration, price of the underlying, and IV.  The only one of these factors not immediately accessible to anyone with a quote screen and a calendar is IV.  It is by changes in the magnitude of IV that future events of potential major import to the price of the underlying are expressed.

As an example of the information that can be gained by considering apparent anomalous values for IV, consider the case of ITMN.  This biotech stock is represented in upcoming expiration cycles of: November, December, January, and April.  Considering the example of the 14 strike call, the IV for these various months are:  54, 65, 78, and 136 respectively.

I have no idea what is up in the first quarter of 2011 for this stock, but the options markets are pricing a substantial probability of a significant price move between January and April expirations.  These types of IV spikes are typically seen in biotech stocks ahead of significant FDA decisions.

Bill Burton, Market Taker Mentoring LLC

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