How To Successfully Use Option Volatility To Trade Binary Events

Contrary to popular investing belief and outdated content, volatility creates opportunities… especially in the options market.

In How To Profit From Option Volatility, I discussed how options theory differs from practice…and how implied volatility plays a factor in that.

One of the points touched in that article, was how uncertainty drives option volatility higher. Sometimes this elevated options volatility is warranted…but many times it’s not.

For example, I know that drug stocks tend to have very high implied volatility levels…however, I also know that they can move a lot (in either direction)…making it hard to justify ever shorting premium in these names.

On September 12th, 2014, there was 20 times usual options volume in Avinir Pharmaceuticals Inc (AVNR). The 30 day implied volatility jumped from 91.9% to 99.19% when the stock was trading around $6.74. The options market was implying around a 29% move in a month.

Sounds pretty overzealous right?

Well, the following Monday, AVNR announced positive Phase II trial results on their Alzheimer’s disease drug. The stock traded over $13 per share…up over 90% ! And get this…option volatility spiked from 99.19% to 128.2%

By the way, detecting this kind of options activity is covered for you in full detail in The SIZZLE Method Report. It’s your nuts and bolts guide teaching you my process how to use unusual options activity to generate winning trading ideas.

Those who bought call premium were heavily rewarded… while those who sold call premium got roughed up pretty bad. These type of plays are high risk/high reward…sort of like gambling and not suitable for most option investors.

For option investors, having undefined risk in( small/mid cap) drug/pharma/biotech stocks should be avoided. The reason being is that these type of wildcard catalysts are a dime a dozen.Literally, coming out of nowhere.

In many of these cases, their options aren’t very liquid either, the difference between the bid/ask is sometimes greater than 50% Slippage is something you must limit as much as possible if you want to be profitable. For a more detailed explanation refer to How You Might Be Losing Money On Your Option Trades

Shorting naked premium without a justifiable reason can be a very costly mistake. Without a game plan, the potential of making a mistake increases substantially. This is probably a reason why so many option investors are scared to take the other side of the buy order.

One reply to How To Profit From Option Volatility was this from, @zzbar on twitter:

I get it…sometimes you enter a position and it goes horribly wrong…you get frustrated, upset and wish you never got involved with it in the first place. Believe me, it’s happened to me before and I’m sure to a whole lot of other folks.

However, there’s ways to reduce the impact of these type of losses…by respecting the power of leverage and sizing your positions accordingly.

My response to @zzbar was just that idea. Keeping risk levels small is one way not to lose your shirt. Check out Why Size Matters; Especially In Options Trading for more on the importance of position sizing.

Also, focus on opportunities that increase your likelihood of success by selling premium where it feels like the option market is grossly overestimating the implied or expected move.

For example, in How To Profit From Option Volatility, we discussed selling a weekly strangle in Apple before their latest product announcement (iPhone 6, iOS 8, iWatch and iPay).

The reason this made sense is because premium levels were juiced…and it felt like investors were overly euphoric. Think about it? Did you really think that everyone would agree on how much value these products would bring to the stock in one single day?

Of course not, the bulls and bears fought all day…ultimately resulting in the stock price barely changing from the previous day.

However, all that hopium was sucked out of that option premium… and that strangle I discussed on Twitter was closed out for a nice profit. Not only that, but there wasn’t much pain involved…an in and out job.

Who would have thought there would be another opportunity just like that one, a week

later.

This time, the hype was surrounded around Yahoo (YHOO), due to their 20% plus stake in Alibaba (BABA).

On Friday, September 18th, Alibaba would become the largest IPO in history.

There was so much buzz around this IPO… it was ridiculous. Everyone was trying to gauge at what price BABA would open up at…how it would perform, was it going to do a Facebook like IPO or fly to the moon?

The talking heads on TV were all praising this mysterious Chinese company. The TV was flooded with interviews of their charismatic chairman, Jack Ma, whose rags to riches story is something out of a Hollywood movie.

With BABA having no listed options on opening day…the focus was on YHOO. On September 16th, 2014, I posted this on twitter:

With the stock trading around $42.70 , The October $37/$48 was priced at $1.60.

(In a minute, I’ll break down the trade in full detail…but before that, let’s try to understand what the hoopla was all about…and why it was probably just all noise)

Some speculators were assuming that if BABA’s price had a massive move higher…it would mean that YHOO’s stock price would end up moving much higher as well.

However, other’s felt BABA was already priced in…after all, YHOO’s stock price increased over 10% the 30 days leading up to the IPO.

We had two camps, one which thought that YHOO would trade in the high 40s- low 50s if BABA exploded…the other, feeling that it was already priced and the stock was more vulnerable to the downside.

There were tax implications involved in YHOO’s stake in BABA…in addition, if BABA performed strongly, those who had BABA stock pre-IPO might be hedging by their position by shorting YHOO because their BABA shares were locked up.

These were very important considerations… seemed like they both had high expectations…but no clear sentiment on where the stock price might go.

Similar to Apple’s product announcement….it would take days to weeks to fully digest the implications of the event. However, all this confusion and uncertainty creates an opportunity to sell rich option premium.

One thing we knew, was implied volatility was going to come down during the IPO and through the end of the day on Friday.

Breaking Down The Trade In Full Detail

Event: Alibaba IPO, investors believe Yahoo’s stake in BABA is going to have a big impact on Yahoo’s stock price that day.

Sentiment: There were two sets of opinions, both presenting compelling cases. However, the uncertainty and the ability to not come to a conclusion (in a short period) creates a big opportunity.

Trade Bias: Non-directional. Basically this means I don’t care if the stocks moves higher or lower…I just want the stock to move less than what the market is implying it will.

The Trade: Selling the October 2014, $37 put and $48 call strangle for a premium of a $1.60

YHOO 1 standard deviation strangle at market close on September 16, 2014

Yahoo (YHOO) stock price was trading around $42.70

Implied Volatility:

YHOO average option implied volatility by each contract month September 16, 2014

YHOO daily price chart with average implied volatility plotted

(Notice how elevated the implied volatility in Yahoo is. It’s very elevated compared to the last 52 weeks. Also notice how it experiences cycles)

The Idea: It will take days to weeks to figure out what the BABA IPO means to YHOO…however, implied volatility should come down, as the uncertainty of how BABA’s stock price will perform will be resolved once it starts trading.

Risk: “Theoretically undefined.” However, we have to put this into perspective. YHOO is a $40 billion market cap company, the chances of it getting bought out overnight is extremely slim considering the circumstances.

Everyone is waiting for the BABA IPO, the likelihood of YHOO gapping up or down, overnight or in the pre-market again is very slim.

The biggest risk when shorting premium naked is overnight or pre-market gap risk.

For a stock like AVNR, this overnight risk is very real. However, when you’ve got premiums juiced in high market cap companies that have a lot of liquidity (in both stocks and options)…the risk is worth exploring…especially when we’re talking about a binary event that is likely going to take some time to figure out it’s impact.

But Josh, doesn’t Tesla Motors fit in this category? Does it make sense to short naked premium in the stock if volatility is high?

First, Tesla is trading nearly $260 a share…that’s a very expensive stock that will require a lot of margin. Second, 23% of the shares floating in the stock are short. That means investors are borrowing the stock to sell it…in some cases they actually have to pay for the borrow.

With that said, on very positive news, the stock has the potential to really “squeeze” higher. What happens is those who borrowed the stock to short will have to cover by buying the stock to close out of their position…in addition, there is also buying pressure from those who want to get long the stock.

Selling naked calls in a stock that has a high short interest does create more risk…and you

should be aware of that.

In the case of stocks like Tesla, you’ll want to do structured spreads to take advantage of high option volatility situations.

Now, Yahoo only had 3% of the shares floating short. The threat of a “short squeeze” wasn’t there. Also, with the stock trading under $45 a share, there wasn’t a lot of margin demand for selling the strangle.

With little overnight and pre-market gap risk…we’d be able to manage the position during the trading day with no problems.

Break-Even: This was a non-directional trade, having no opinion on where the stock will go. The break-even at expiration is:

$48 + $1.60 = $49.60 upside

$37 – $1.60= $35.40 downside

Ok, if the stock is trading at around $42.70, that gives us a range of 16% towards the upside to -17%. A lot of magic would need to happen for me to start feeling some pain. And at expiration I’d be profitable anywhere from $35.40 to $49.60.

That’s a very solid cushion given the stock and the circumstances…

I probably will have plenty of time to make adjustments if things were to get out of hand.

But here’s the thing, this is a binary event trade with no intentions of staying till expiration …and trying to collect the full premium. The play is to buy back the options after the volatility collapses… at sometime during the BABA IPO.

Note: If you’re using a risk analyzer for these type of trades…do a what-if analysis on different changes in implied volatility to get an idea of what your position will look like.

For example, if implied volatility on your options is 80% …how much would they be worth the next day if implied volatility was lower, say 60%? This is done to get an idea, we won’t know for sure what the actual drop will be.

A lot of times, an event is overhyped…traders who bought calls and put options expecting a major move…become disappointed…and start hitting the sell button trying to salvage whatever premium they have left…which causes option volatility to drop.

The reason I chose October strangles vs. the weekly strangles is because I wanted to be short more “vega” or option volatility. By shorting near term options, I would have been short less “vega” …but have greater directional risk in the form of “gamma”…gamma refers to the option greek that tells us how much the delta will change.

By going out a little further in time, your trade focus is more on the moves in implied volatility

(vega) vs. short term volatility (gamma).

Well, the day of the IPO, it almost seemed like the entire market was on pause, waiting for Alibaba to start trading. The underwriters had priced the stock at around $68 or so…but everyone knew that it was going to open up around $90 per share.

It eventually opened around noon Eastern time, in the $90s….went vertical touching nearly $100 per share…sold back down to the $90s…and was pretty much in cruise control the rest of the day…closing at $93.89 per share.

Folks, this is a company that has a market cap larger than Amazon.com …how much volatility were you expecting?

To the surprise of the bulls, Yahoo started to sell off….possibly for some of the reasons mentioned earlier in this article. Intraday, the stock experienced a decent amount of volatility, hitting a high of $42.40 and a low of $39.55.

However, leading up to the event there was too much euphoria and the stock eventually settled in and closed down 2.76% from the previous day.

Option volatility collapsed, as the 30-day atm implied volatility changed -15% from the previous day.

YHOO average implied volatility by each month September 19, 2014

That strangle mentioned on twitter worked like expected and closed out for a nice profit that day.

YHOO 1 standard deviation strangle closing price on September 19, 2014

This is really one of those textbook plays on how to short volatility into an event that is most likely going to be a non-event.

What You Can Take From This Article:

• Shorting naked options is not suitable for every stock. Low market cap stocks are vulnerable to being taken over through an M&A. In addition, stocks with high short interest have the potential to have an extraordinary move (short squeeze).

• Find opportunities in stock options that offer great liquidity, competitive bid/ask spreads…where you feel option volatility is elevated because of market euphoria….unlike a biotech/pharma stock where high volatility levels are justified.

• Trading options on high cap stocks makes sense…it will take a lot of unanticipated news to really move the stock. Yahoo circumstances fit this really well.

• By going out to 30 days you are able to sell more of that option volatility (vega)

• The focus was to get out of the trade during the day of the IPO…with the idea that it would take a couple days to weeks to fully grasp what this meant to Yahoo…while the implied volatility gets sucked out of the premium.

• Low priced stocks like Yahoo have smaller margin concerns. However, you should still size your trades accordingly so there is some margin for error.

By the way, did any trade it similar to this trade?

To be honest, this seemed like a layup… unfortunately, options investing is not always this easy. Often times, you’ll be tested when you’re short premium and be forced to take some form of action.

However, it’s important to find situations where the market has to beat you in order for you to lose money vs. getting caught up in the euphoria and chasing…like we recently saw in Apple and Yahoo.

Do you think you’ll be able to spot the next opportunity like this if you see it? I’d love to hear from you… I’ll be hanging out in the comments section below.

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