How Option Volatility Can Increase Your Probability of Success

One of the biggest reasons investors are scared off by options is because they fully don’t understand them. It’s true, one of the toughest concepts to grasp for equity investors transitioning into options investing is understanding how option values are derived.

With stocks it’s very simple to understand, for every dollar the stock price rises you lose $1 per share…on the flip side for every dollar the stock price drops you lose $1 per share. This is referred to as a linear relationship.

Now, when it comes to options investing the relationship is non-linear. You see, not only are options influenced by the price movements of the underlying stock, but time to expiration, volatility and option strike price selection all play a major factor.

For example, there are cases when a stock price can rise and the call options lose value. If you didn’t know better you’d think that options were manipulated by market makers.

However, this isn’t true.

For an in depth explanation, feel free to go back to The Ugly Truth about Buying Options and watch the How To Buy Options For Better Results inspired from that article.

Moving on, the most interesting component pertaining to how options are priced is implied volatility. But before I get into that, it’s important to give you a little insight into options pricing theory.

Options are priced using a probability model. One of those assumptions in that model is that equity prices follow a lognormal distribution.

In theory, equity prices cannot have negative prices and can rise exponentially higher…because of this, the skew is shifted more towards the right. Now, the normal distribution…which is commonly referred to as the bell-curve is used to model returns.

For the most part, options are priced using the Black-Scholes formula or a variation of it. The (Black-Scholes formula is only suitable for European Style Options.

European Style options are simply options that can only be exercised at expiration. Now, American Style options can be exercised at any time before the option contracts expire.)

With that said, on my thinkorswim platform, the Bjerksund-Stensland model is used because it’s able to get more accurate prices for American options. However, the formulas are very similar.

Furthermore, the Black-Scholes formula uses the normal distribution in their model. (But the inclusion of exponential functions makes the distribution lognormal.)

If this isn’t clicking yet… just take a look at next image:

Option theory assumes that daily returns will follow a normal distribution (outlined in red, the actual distribution is in blue)….as you can see, this isn’t a perfect fit.

The next term you should familiarize yourself with is standard deviation.

Now, standard deviation is the statistic used to measure the amount of variability (randomness) around the mean (the highest point on the bell-curve). The option pricing model uses standard deviation to measure volatility.

In the above example we looked at a one year chart of daily returns (in % terms) for Apple. The chart compares the theoretical normal distribution to the actual distribution.,

The mean was 0.2% and the standard deviation was 1.37%.

So if the average daily return was 0.2% during the sample period, 34% of the daily returns would be within the one standard deviation of 1.37%. Now if you went from -1.37% to 1.37% that would include 68% of the daily returns.

Let’s assume that Apple is trading at $102 per share. A (+/-) 1 standard deviation move would encompass about 68% of the normal distribution. The theory is saying that on any given day,

Apple stock price will be within a +/- $1.40 move 68% of the time (given the stock price at $102).

Now, to figure out what a (+/-) 2 standard deviation move would be, simply multiply (+/-) $1.40 by 2. This is equal to (+/-) $2.80. According to our sample, Apple stock price moves will be within a (+/-) $2.80 move on a given day 95% of the time.

Let’s take a look at another stock, Tesla Motors.

During this sample period, the the mean was .2% and the standard deviation was around 3.44%.

If Tesla is trading at $279 per share, 68% of the time, the daily price move will be within (+/-) $9.60 according to the normal distribution.

Takeaways So Far

• Options are priced using a probability model.• The option pricing formula assumes that

returns are normally distributed.

• Standard deviation is used as a volatility measure.

• Implied volatility is the direct measure of how much the market thinks the underlying’s price might change. It’s a reliable metric to predict the range of future price changes.

How good are the assumptions?

Stock returns do not follow a normal distribution. If you look at the Tesla chart above, you’ll notice daily returns around the mean occurred more often than the model anticipated. In addition, there were several more outsized returns than the model anticipated.

Looking at the Apple chart, there were more negative than positive returns. Both charts experience fatter tails, notice at the end of the normal distribution the odds of extreme price moves are very small.

However, in reality, extreme price moves in stocks happen a lot more often than the normal distribution assumes. A quick look at the Tesla chart above will show you what I mean.

Here’s another assumption:

The option pricing formula assumes that volatility is constant. In practice, you’ll notice that each option strike has it’s own volatility.

In fact, option volatility or implied volatility is not derived from historical price returns.Implied volatility is derived from the flow of options.

Why does implied volatility vary amongst option strike prices?

Well, for one reason, market participants know that stock price returns don’t follow a normal distribution. As you’ve seen from the previous charts above…stock price returns have fatter tails.

Also, one of the driving factors behind implied volatility is supply and demand. For example, On September 12, 2014, there were some rumors circulating that Google might have an interest in Ebay’s PayPal.

The thought was that Google’s Wallet was sort of a failure and the emergence of Apple Pay would take market share away from them. Of course, this was all speculation, but that didn’t stop the option market participants from placing their bets.

On that day, there were nearly 220,000 Ebay options traded…4.3x usual options volume. The 30 day at-the-money implied volatility jumped 5.6 points to 27.9%. This increase in option volatility was driven by the demand for option premium.

By the way, in the above examples, we were looking at volatility in terms of daily returns. However, options are expressed in annualized returns.

To convert annualized volatility to daily volatility, take the annualized volatility and divide it by the square root of the number of trading days (252). For example, .279/15.87 = .0175 or 1.75%. In EBay, a one standard deviation move is a +/- 1.75%.

As mentioned, demand for options shifts implied volatility. The more demand for an option, the more expensive the options become…on the flip side, if there is large selling in options, volatility drops.

What else?

Well, uncertainty causes option volatility to also increase. This typically happens ahead of an earnings announcement, a company product announcement, pending FDA announcement etc.

Implied volatility can spike off news rumors, like the one mentioned with EBay. It can also spike due to rumors or chatter like an activist might be involved or the stock has become an M&A target and a whole bunch of other stuff.

Bottom line, uncertainty creates option volatility to increase.

Of course, the price action in the stock could also drive speculators to pay up for options in fear that they might miss the next big move. For example, GoPro has risen from $40 per share to nearly $70 over the last month.

On, 9/11/14, The October $100 calls were $0.35 bid at $0.40 ask. That’s another 40% plus move needed in a month’s time! Could the stock really go from $40 to $100 in two months? Sure, but you have to think that some investors are feeling euphoric.

To be honest, some of the best opportunities are those in which you can spot that euphoria. You see, when I’m selling option premium, I try to find trades in which the market has to do something mind-blowing to beat me.

One of these opportunities happened recently ahead of the big Apple product announcement. Now, this was heavily anticipated and some believed it was going to be the biggest product launch they’ve had in years…there was a ton of rumors on what they might be rolling out.

I think everyone knew that they would introduce the newest version of the iPhone. Other speculation was on an Apple TV or some kind of wearable. There was a lot of buzz around it… in fact, it was even reflected in the way the options were priced.

With the stock trading at $98.38 on the day before the announcement, the $99 straddle was implying around a +/- $4.20 move by Friday….which was over a 4%.

Keep in mind, ahead of this announcement there was a great degree of uncertainty, how would the market react to their new products? Was this going to be a game-changer like the iPhone or iPad?

One thing was sure, once the news was fully digested, implied volatility was expected to come in pretty hard.

By the way, if you are stuck on what the implied move means…make sure to review Don’t Trade Earnings Before You Read This

I was looking for a trade that benefits from time decay and the inevitable decrease in implied volatility.

In this opportunity, I was looking at this… a short strangle:

Note: These are the closing prices of the strangles on August 8, 2014

The first trade was selling the $102 calls and $94 puts for a premium of $1.36 (weekly options expiring that Friday)

This means my break-even points would be $103.36 (an all-time high) and $92.64 (September contracts expiring in 11 days)

The second trade was selling the $103 calls and $92.5 puts for $1.51.

This means my break-even points were 104.51 and $91

Technically, my risk is not defined because Apple could “theoretically” go to “infinity” or zero

However, we’ve already witnessed how accurate theory is.

Some of you might be thinking that selling strangles is very risky. In some cases, it can be.

However, you’ve always got to look at the stock you’re involved in. For example, there is always overnight risk, the stock could have a huge gap up or down.

So I’ll walk you though my thought process…

Apple is a $600 billion dollar market cap company that actually makes money…for the stock to have a massive gap up or down…a lot would need to happen. It’s not like Apple is an M&A target for anyone…they are the ones who do the acquiring.

Even though my risk was “theoretically unlimited”, I really didn’t think there was a lot of overnight and pre-market risk.

Also, Apple is a lower priced product after its split a few months ago. That means the naked options will not take up as much buying power as it would have before when it was a $600 stock.

In this case, I was expecting implied volatility to come in hard and fast…this is not something I was planning on holding till expiration….if things go as planned, I’d be out in less than 24 hours.

Well, on September 9th the announcement was made…Apple displayed a bigger, new iPhone, Apple Pay and the Apple iWatch. Some people loved the concepts…some people hated them.

The stock moved from being negative to positive to negative…resulting in a -$0.37 change in the stock price from the previous day.

But guess what? The option premiums got absolutely crushed. At the end of the day, the price of the first strangle (-1 102 call/ -1 94 put) could have been bought back for $0.34 and the price of the second straddle (-103 call/ -1 92.5put) could have been bought back for 73 cents.

As you can see, my bet was not on the Apple product announcement as much as it was on how the option participants were expecting the Apple announcement to play out. Like they say, a good poker player doesn’t play his cards…he plays his opponent.

Why get out that day and not look to capture all of the premium? Well, this particular play was based off the idea that the option market was overestimating the impact of the product announcement.

I also knew that after an event, the uncertainty disappears and implied volatility drops. Once that happened there was no reason to be in the position.

I achieved the best return on capital in the shortest amount of time with the highest chances of success. Staying in that position changes my risk dramatically and exposes to me to gamma risk.

A common reason why short premium option trades don’t work for investors or traders is because they sit in them too long trying to get every penny possible. This is why I wrote, “Greater Profits In Less Time On Your Option Trades”

Looking at the longer term implied volatility chart, you can see how quickly the volatility came back in. In regards to those weekly options, the ATM straddle went from 44% to 27% in one day.

It’s vary rare, but sometimes high implied volatility is justified depending on the underlying and you’ll want to avoid.

However, if you want to create long term success with options, especially in today’s market where euphoria or fear take over. It’s situations like that, which make selling option premium allows you to get the laws of probability on your side!

Key Takeaways For Your Success

• Unlike options theory, option volatility or implied volatility is a function of supply and demand.

• Uncertainty or binary events causes implied volatility to move higher.

• After an event, implied volatility gets sucked out like a vacuum because the uncertainty disappears.

• Selling strangles does not make sense with every stock, risk defined strategies like iron condors and butterflies could more appropriate for your account and risk tolerance.

• “Theoretically” risk is not defined when selling strangles. However, given the right market conditions and a stock that isn’t overly vulnerable to overnight or gap risk.. it can be a very profitable over the long term.

• Try to identify why the implied volatility is high and if you feel it’s justified to take on the risk.

• When selling premium it’s important to not over leverage. For a review, read Why Size Matters; Especially In Options Trading

Make no mistake about it, investing successfully with options is not easy. However, part of becoming profitable is identifying opportunities and then trying to take advantage of them. Situations like this example in Apple don’t happen everyday…but when they do, will you be ready for them?

When I’m entering short premium trades my thought process is that the market is gonna have to beat me with something exceptional for me to lose money. With that said, I don’t believe in selling premium blindly without a good reason.

How about you? Do you tend to mix it up between premium buying or selling? Or do you stick to one method or strategy? I’d love to hear your thoughts…I’ll be hanging out in the comments section below.

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