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October 24, 2013

Implied Volatility and the Debt Ceiling Crisis

In the last couple of months, the market has shown some good movement. The S&P 500 and Dow set their all-time highs and then promptly moved lower. Washington struggled to find common ground which in turned partially shutdown the government and moved stocks all around. Now we are in the middle of earnings season and the roller-coaster ride may continue. It is important for option traders to understand one of the most important steps when learning to trade options; analyzing 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 process making some trades losers from the start. An option trader needs to look back at the last couple of months of option trading to see how volatility played a crucial part in option pricing and how it will help them going forward.

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 30 historical volatility is less volatile than a stock with a 35 historical volatility. Additionally, a stock with a historical volatility of 45 now is more volatile than it was when its historical volatility was, say, 30.

In contrast to historical volatility, which looks at actual stock prices in the past, implied volatility (IV) looks forward. 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 20 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. A recent example of the implied volatility increasing was the debt ceiling crisis. There was some concern that the government would not hammer out a compromise and thus default which put fear into the market and increased implied volatility.

Analyzing Volatility
Implied volatility and historical volatility is analyzed by using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are misinterpreted by new or less experienced option traders.

Regular users of volatility charts 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

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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 where the story ends. 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 sell; if it is below its normal level it may still be a good buy.

Finally, 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 known as the skew 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 different like an expected earnings announcement or a general fear of the economy. 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 and that is precisely what every trader needs.

Just a heads up…there is another government deadline coming early next year that might provide for another implied volatility skew. Get ready!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 14, 2013

Six-Year Low in the VIX? What’s It Mean to YOUR Options Trading?

The VIX, or CBOE’s Implied Volatility Index, hit a six-year low this week. What’s that mean to options trading? Lots!

Options trading is greatly affected by implied volatility. At its most basic level, when the VIX is low, it tends to mean lousy options trading.

Option traders are not incented to trade when the VIX is low. Traders generally don’t want to sell options when premiums are so low. There is no reward and still there is always the specter of the risk of an unexpected market shock. And, option traders don’t want to buy options either. Why? Because when the VIX is low, the VIX low is for a reason: Because market volatility is low. Why would traders want to buy options (and endure time decay) is the market isn’t moving?

And so, as always, the devil is in the details. Right now, there actually exists a somewhat atypical pattern in many stock options. Many stocks have their implied volatility trading decidedly below historical volatility levels. Though this volatility set up can be seen here and there at any given time, it is more common than usual. That means cheap volatility trades (i.e., underpriced options) are more abundant.

Stocks like CRM, C, GE, F, and even the almighty AAPL all have implied volatility below their historical volatility.

That means

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that even though overall stock volatility (as measured by historical volatility) is low, the options are priced at an even lower level. That means time decay is very cheap per the level of price action in these stocks. And, implied volatility in these stocks (and probably the VIX as well) is likely to rise to catch up to historical volatility levels—assuming the current price action continues as it is.

So, traders should be careful not to sell too many option spreads (i.e., credit spreads) at these fire-sale levels. Instead, traders should look to positive vega spreads (i.e., debit spreads), at least until implied volatility rises offering worthy premiums to option sellers.

Dan Passarelli

CEO

Market Taker Mentoring

February 21, 2013

Expiration Week: Butterflies

One of the major differences when learning to trade

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options as opposed to equity trading is the impact of time on the various trade vehicles. Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in the same month. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the beast becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 1, 2012

The Naked AAPL Call

The naked call is defined as an option strategy where an option player sells (writes) call options without owning the underlying security. Some may refer to this strategy as an “uncovered call” or “short call.”

The goal of the naked call is for the trader to collect premiums if the option expires worthless. A trader could sell an out-of-the-money (OTM) naked call each month and pocket premiums, provided the stock price either stays flat or drops. This process could continue as long as the stock remains below the strike. For those interested in learning all the ins and outs of naked calls and possibly safer alternatives, please visit the Learn To Trade section of our website.

The Specifics
The maximum gain for selling a naked call is limited to the premium received for the call option. That said, the loss potential is unlimited – as the stock can rise indefinitely. If the underlying stock’s price is above the strike price at expiration, it will result in the trader having to sell the stock at the strike price (which will be lower than the market price).

A loss can occur if the stock price rises. If the price of the underlying stock is greater than the short call’s strike price plus the premium received at expiration the option should be bought in to close the trade. Otherwise, when the option is assigned and a short-stock position is acquired, further losses are possible. On the flip side, the maximum profit is achieved when the underlying stock is less than or equal to the strike price of the sold call at its expiration.

An Example
For this specific example, we will take a look at Apple (AAPL) – which is trading right around $600 at the time of this writing. A December 650 call carries a bid price of 7.00. If the stock remains below the strike price by expiration, the call expires worthless and the call seller keeps the 7.00 in premium (less any commissions). The problem is if the stock rallies through the strike price at expiration, the call will be assigned, resulting in a short sale of 100 shares at $650. With the stock at $670, that would represent a loss of $20 a share, or $2,000. Subtract the $700 received in premium and the total loss comes to $1,300.

With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A, perhaps, safer way to structure a trade with a similar risk profile is to sell a call credit spread. We’ll have a short blog posting on this in the future.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 19, 2012

Expiration Week: Butterflies

One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade vehicles. Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in

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the same month. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the beast becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 15, 2011

Expiration Week: Butterflies

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 1:34 pm

One of the major differences in option trading as opposed to equity trading is the impact of time on the various trade vehicles. Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an

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option premium goes to 0 at the closing bell on expiration Friday.

While this decay of time premium to a value of 0 is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in the same month. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the beast becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.