“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.
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
For contrarian traders looking to short Thursday’s explosive price move in NFLX, two bearish trades had dramatically different success as the price of the underlying declined into the afternoon. As is often the case, you can learn a lot just by watching and analyzing the sequence of events in autopsies of the trades.
In order to set the stage, NFLX closed on Wednesday at $107 and the implied volatility (IV) of the front month at-the-money puts and calls averaged 57%. Options of NFLX are very liquid and were trading with reasonable BA spreads.
By 10:30 AM, NFLX price had risen dramatically to $117.46. For the trader who wished to take a contrarian view, he could have purchased the out-of-the-money May 115 puts, the then at-the-money strike for $4.95. Importantly, the IV was 84%. Another trader who prefers to sell premium, could have sold the slightly out-of-the-money calls, the May 120 strike, for $5 at an IV of 84%.
At 2:00 PM the stock had sold off to $113.96. How did our two traders fare? The put buyer could have sold his position for $5.60 for a net profit of 65¢ on the initial position. The premium seller would have been able to close his call position for $2.70 for a gain of $2.30. Both positions were closed at an IV of around 71%.
What is the explanation for the disparity in the results? The reason is volatility crush. Both positions were initiated at an IV of 84% and closed at an IV of 71%. However the call sale represented a vega negative trade while the put buy was a vega positive trade. Volatility had exploded upwards with the dramatic and sudden price rise.
Although IV is generally considered to be inversely related to price, it is important to realize that it can also spike with dramatic and rapid price rises. The outcomes of these two different trades emphasize the importance of considering IV as well as price when designing option trades.