October 12, 2012

Volatility Events, Predictions and a Piece of Cake

Option trading is easy. Well, let me qualify that statement just a bit. To be fair, options are more complicated than more simple, linear assets like stocks. But there are some elements to options’ pricing that actually make them a little easier to trade from a valuation standpoint. To find out more about this feel free to visit the options information section of our website.

The most important thing to consider is predictability. You probably receive many unsolicited emails telling you how so-and-so can predict the market with 100% certainty and make you a billionaire overnight. On the other side of that coin, there is not a professor alive who will tell you that it is possible to predict the direction of the stock market with any statistical significance. The truth probably lies somewhere in the middle. But one thing for sure: predicting the direction of a stock is though, and you’ll be wrong often.

But, aside from directional implications of the underlying stock, there is an important pricing factor to options that is much more predictable: volatility shifts resulting from expected volatility events. All options have an imbedded component to their pricing relating to expected-future volatility. This is called implied volatility. It can be thought of as the expected future volatility implied by the market.

Sometimes volatility is quite predictable, and therefore, fluctuations in option prices resulting from implied volatility changes can be likewise predictable. So-called volatility events include earnings, Fed announcements, CPI, PPI, Retail Sales, Payrolls, GDP and more. Volatility events are often scheduled far in advance. Just google a financial calendar and see when CPI is scheduled to be released six months from now—you’ll easily find that information. Unemployment figures are always the first Friday of the month. And so on.

When volatility events are imminent, options get more expensive. Why? Hedgers and speculators brace for a potential move by buying options, creating price-pressuring demand. Look at a chart of implied volatility for a typical stock option class and take a look at its value in the few days leading up to earnings. Typically, it will increase right before earnings. Then afterwards, it tends to fall right back to its normal range.

Scheduled volatility events help option traders analyze the ebb and flow of option premium levels with the precision of predicting the moon cycle. But all volatility events are not predictable—only those that are regularly scheduled. Sometimes, volatility events come out of nowhere. Takeovers, CFOs cooking the books, these sort of things can take a trader by surprise.

Though not all volatility events are predictable, the fact that some are provides great value to option traders. Imagine knowing that a stock

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would almost always rise at a certain date every quarter! This makes option trading a little easier than stock trading in my opinion. Maybe not quite a piece of cake; but still advantageous over trading stocks.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring