Profiting With Changes in Implied Volatility
Tuesday, September 5, 2006 at 02:58PM
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.
Reader Comments (10)
Great post!!
Jeff H. DC
Iron Condor?
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
The options you bought still had loads of time value attached, and this is why you felt it.
Presently i''m in a position to have a short Vega because if the volatility retains a high position it means the market values are falling down and vice versa . Anyone should must have all the basics about all types of volatility like implied, historical and theoretical.
Implied volatility
This blog Is very informative , I am really pleased to post my comment on this blog.
Stock tips
links of london is a very reputed company true religion jeans sale that is well known for its wide range of available products,cheap links of london hassle free buying, links of london wholesale fast shipping and safe shopping. discount links of london Founded in 1990 Links of London links of london sale is the result of the commission of a local restaurant owner Links of London has earned a lot of awards Bangles including the award for the best jewelry brand for the year 2007.Rings So if you are looking for cheap true religion jeans cool, funky, crazy or elegant styles of jewelries. Earrings jewelry is the best place for it to start your Pink Zebra CHI online shopping.Rings jewelry proudly presents to Watches its customers flavorsome jewelries of wide assortments. BraceletsThey range can start from any kind of chi flat irons cheap jewelry like bracelets to anklets. Watches It provides London jewelry that includes Women's Bootcut bracelets, necklace, rings, chains, earrings etc. CharmsThe links provided are all authentic and cheap true religion jeans on sale the prices charged for them are the lowest possible charges. links of london wholesale The site has all sorts of jewels lined up on display in the site. p90x wholesale So you can choose from all the ranges and designs we have to offer. discount links of london You pick one according to your style. Earrings If you are looking for something classy choose from chi flat iron sale the classic range. Charms If you are a teenager, cheap true religion jeans then you can go for the more funky and bizarre collection. cheap p90x You will get all types of colorful and sterling jewels. true religion jeans sale You will also get choices of watches and accessories. p90x dvd setYou can also get jewelries of a variety of cheap true religion jeans on sale metals like gold, silver, platinum etc. p90x wholesaleThe service rendered by Pink Zebra CHI Links of London jewelry is excellent and doubtlessly of top quality. links of london Besides offering affordable price for Men's Flare all types of commodities it provides MEN'S JEANS unquestionable security for the customers. links of london sale The company is reputed for its quality service. cheap links of london The competitive price offered is a thing to look forward to Men's Bootcut while buying things here. Bangles You can make you choice online and Men's Bootcut place your orders by the same. BraceletsShipment process is also fast and undisputed. cheap p90x Through advanced ordering systems on online basis Men's Flare you can make your payment in the mode favorable to you. cheap p90x Tracking and payment are done very fast. p90x wholesaleThe service offered to CHI Zebra Ceramic Collection the customers is highly professional.p90x dvd setThere is also an online Men's Straight Leg support for customers throughout the day. p90x dvd set This service is available 24/7. MEN'S JEANS Please feel free to get in touch with us in case of any enquiry. p90x for sale This service is mostly meant for all those customers p90x for sale who have any questions regarding products they want to buy Men's Straight Leg or about products they are already using. p90x for sale The online customer care executives will answer all your inquiries and Men's Skinny the entire process will be done adequately and quickly. p90x 13 dvd set cheap You can also comment on any of the products online. p90x 13 dvd set cheapSo with Links of London Jewelry fitness guide p90x you can not only experience a visionary exhibition of the best collection of jewelries p90x 13 dvd set cheap but also the best among the contemporary styles and designs. fitness guide p90x You can also check out collections from different trade names. fitness guide p90x So this is where you get all kinds of Men's Skinny traditional British jewelries befitting the style of both old and young. cheap p90x So rediscover style and fashion through jewels. cheap p90xBack in the 1970s and 1980s, chi flat irons cheap there were Jordache, Women's Skirts&Shorts Calvin Klein and Gloria Vanderbilt. Women's Skirts&Shorts These were the brand name designer jeans for women that took the world by storm. Women's Bootcut If you weren't wearing one of these brands then,chi flat iron Pink to other people, chi flat iron you weren't on the up and up.chi flat iron saleNow, fast forward to at least thirty years later and chi flat iron you have another group of brand name designer jeans that have made it to the forefront. chi hair dryer sale These women designer jeans are top-ranked in America with their different fit and styles.chi hair straightener Hudson Jeans originated in the Los Angeles area. chi hair straightener Their styles are created with an artsy look. chi camo flat iron The company uses the best materials from Japan, Europe, and the United States. chi camo flat iron The finishing touches are done by hand. The jean material is treated in the company's factory. chi hair dryer sale When the pairs of jeans are finished and ready for distribution, each pair will be different from the other. chi turbo hair iron No pair of jeans is like another. chi turbo hair iron The long legs are made lean, CHI Zebra Ceramic Collection and people that wear them feel the fit is jut right for them.
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
mac makeup
<p>New York Yankees Hats</p>
<p>San Diego Padres Hats</p>
<p>San Francisco Giants Hats</p>
<p>St. Louis Cardinals Hats</p>
Cheers for the info. Greatly appreciated.
gucci womens shoes
gucci mens shoes