Post feedProfiting With Changes in Implied Volatility
In our prior discussions on the vast subspaces of Implied Volatility we have gutted out much of it's presence and it's impact on option pricing. What we have not discussed is other applications around this phenomena. I am going back to this in an effort to answer questions I have seen posted in the comments and to answer the plethora of e-mails I have not ponied up an answered to yet.
In an earlier post I mentioned buying ITM options to render IV obsolete. Options with good amounts of intrinsic value come with less time value than ITM or OTM options in some instances. With smaller amounts of time value, this dampens the effect that IV has on your option price (Remember IV can only effect time value, not intrinsic value). But what if you don't want to buy deep ITM options? I don't blame you!
Let's discuss how to profit on changes in IV. What if IV is high, and you are expecting it to drop substantially, or vice versa? Let me give you an example I will normally trade. Straddles work well not only in situations where you are expecting a big change in price, but also when you are expecting a big change in IV. There are a few tips I want to give you about trading this strategy.
First, if you are going to trade a straddle or strangle, please don't get in the day before the announcement when the options are trading at their very highest premium. Why not get in early? I normally try to get in 2-3 weeks prior to, while IV is still rising. If you do this, and the price doesn't move too much, then both the call and put should have increased enough in value to exit the trade before earnings with a decent profit. The typical scenario I see, is people getting in right before the announcement...which is ok if you get a monster movement in price. A monster move in price will pay for both expensive options you've purchased. But there is a big pressure on you to get this large move. If you don't, you stand a lesser chance of profiting from this trade. This is why you will hear that these trades only work 30-40% of the time, is due to the entry of extremely expensive options. Make sure you consider an early entry next time to consider this strategy.
What if you are in a "day before" earnings environment or another circumstance where you anticipate IV to change drastically? Have you ever heard the term delta-neutral? Delta-neutral describes a situation consisting of positions with offsetting positive and negative deltas. The deltas balance out to bring the net change of the position to zero. This means with a delta of zero, the price can move up or down, and you will remain even on the trade. No gain, no loss. Now that I am numb to moves in price, if I am expecting a move in volatility this is where I need to focus on vega.
If I am expecting volatility to rise substantially, I want to be long vega (positive vega). If I am in a situation I mentioned earlier, day before earnings and expecting IV to crash, I want to be short vega (negative vega position). Shorting vega with a high IV, gives a neutral-position delta strategy the possibility to profit from a decline in IV, which can occur quickly from extremes levels. Of course, if volatility rises even higher, the position will lose money. As a rule, it is therefore best to establish short vega delta-neutral positions when implied volatility is at levels that are in the 90th percentile ranking. This rule will not guarantee a prevention against loses, but it does provide a statistical edge when trading since IV will eventually revert to its historical mean even though it might go higher first.
Hopefully this provides a few nuggets of information to help you understand the importance and impact volatility has and how to utilize vega in an option trade. Straddles can be a great strategy for both price and volatility movements, you just need to make sure you are creating the right trade to profit from this environment. This might be a lot to swallow, but read through it a few times and practice. As you progress through advanced options trading, this will become very important to you somewhere down the road.
In an earlier post I mentioned buying ITM options to render IV obsolete. Options with good amounts of intrinsic value come with less time value than ITM or OTM options in some instances. With smaller amounts of time value, this dampens the effect that IV has on your option price (Remember IV can only effect time value, not intrinsic value). But what if you don't want to buy deep ITM options? I don't blame you!
Let's discuss how to profit on changes in IV. What if IV is high, and you are expecting it to drop substantially, or vice versa? Let me give you an example I will normally trade. Straddles work well not only in situations where you are expecting a big change in price, but also when you are expecting a big change in IV. There are a few tips I want to give you about trading this strategy.
First, if you are going to trade a straddle or strangle, please don't get in the day before the announcement when the options are trading at their very highest premium. Why not get in early? I normally try to get in 2-3 weeks prior to, while IV is still rising. If you do this, and the price doesn't move too much, then both the call and put should have increased enough in value to exit the trade before earnings with a decent profit. The typical scenario I see, is people getting in right before the announcement...which is ok if you get a monster movement in price. A monster move in price will pay for both expensive options you've purchased. But there is a big pressure on you to get this large move. If you don't, you stand a lesser chance of profiting from this trade. This is why you will hear that these trades only work 30-40% of the time, is due to the entry of extremely expensive options. Make sure you consider an early entry next time to consider this strategy.
What if you are in a "day before" earnings environment or another circumstance where you anticipate IV to change drastically? Have you ever heard the term delta-neutral? Delta-neutral describes a situation consisting of positions with offsetting positive and negative deltas. The deltas balance out to bring the net change of the position to zero. This means with a delta of zero, the price can move up or down, and you will remain even on the trade. No gain, no loss. Now that I am numb to moves in price, if I am expecting a move in volatility this is where I need to focus on vega.
If I am expecting volatility to rise substantially, I want to be long vega (positive vega). If I am in a situation I mentioned earlier, day before earnings and expecting IV to crash, I want to be short vega (negative vega position). Shorting vega with a high IV, gives a neutral-position delta strategy the possibility to profit from a decline in IV, which can occur quickly from extremes levels. Of course, if volatility rises even higher, the position will lose money. As a rule, it is therefore best to establish short vega delta-neutral positions when implied volatility is at levels that are in the 90th percentile ranking. This rule will not guarantee a prevention against loses, but it does provide a statistical edge when trading since IV will eventually revert to its historical mean even though it might go higher first.
Hopefully this provides a few nuggets of information to help you understand the importance and impact volatility has and how to utilize vega in an option trade. Straddles can be a great strategy for both price and volatility movements, you just need to make sure you are creating the right trade to profit from this environment. This might be a lot to swallow, but read through it a few times and practice. As you progress through advanced options trading, this will become very important to you somewhere down the road.
These are the kind of posts that make this blog a one-of-a-kind. It's fun and extremely educational! Thanks Jeff!
Posted by
Anonymous |
9/05/2006 09:41:00 PM
Could you give a quick example of a short High Vol. Delta Neutral spread?
Iron Condor?
Posted by
Anonymous |
9/06/2006 12:32:00 AM
Jeff,
I want to point out that buying ITM options doesn't necessarily render IV obsolete. I bought GOOG $400 puts when the stock was trading $387, but unfortunately hadn't learned about IV yet. The stock dropped $10, yet my options were DOWN money still due to the steep drop in IV.
True, those options are LESS affected by IV, but it's still important to check.
Brett
Posted by
Anonymous |
9/06/2006 09:14:00 AM
Those puts are not exactly "deep" ITM options, which is what I mentioned you want to buy to dampen the effect IV has. Had you gone with a deep ITM option where you are buying minimal time value, you will see exactly what I meant.
The options you bought still had loads of time value attached, and this is why you felt it.
Posted by
Option Addict |
9/06/2006 09:24:00 AM