IV typically gets high when the company has news or some event impending that could move the stock – I call it the event horizon – and I refer to this kind of volatility as event volatility. These stocks sometimes are called “situation” stocks. You could say that IV “bakes” the market’s assessment of a likely stock move into the option price. But event volatility is not the only cause of high premium. Here are its main causes:
- There is an event horizon pending on the stock (earnings report, FDA ruling, etc.)
- Significant news is pending on a larger company in the same industry (a bellwether stock) that the smaller company’s stock price follows.
- The company’s industry is currently volatile, or imminent volatility is expected or possible;
- The stock has a high level of historical volatility, so its options normally are expensive; thus high premium and IV simply reflect normal volatility.
- Anomalous cases – there is no apparent reason for expensive options.
– Usually small, undesirable companies, these are to be avoided.
Obviously, when a stock is already moving – it is actually volatile now – option premium will be quite high. IV will simply reflect the volatility, though it might be even higher. Also, when a stock is in a strong trend or otherwise has proven technically reliable, options tend to be expensive. If such options were cheap, Wall Street would literally be giving money away.
Example: Through much of 2006 and 2007, Allegheny Technologies (ATI) was in a strong uptrend, regularly pulling back to the 50-day moving average and resuming its trend. It was a reliable money-maker for option bettors, who bought calls at support and sold puts at anticipated failure levels. Options on such a stock usually are expensive.
Taking Advantage of High Implied Volatility
It is axiomatic that traders should buy low implied volatility and sell high implied volatility. But selling options with low implied volatility means accepting low returns on call writes, which cannot be considered good risk management if IV is out-of-line lower than historical volatility. Those writing portfolio stocks of course have no choice, since premium is what it is.
Time value that is inflated due to spiking implied volatility will collapse when the event causing the spike finally arrives. It is common – on good companies – for the high IV to collapse without a corresponding collapse in the stock’s price. If high IV heralded a sure movement in stock price, then everyone would get rich simply by purchasing the overvalued options… which wouldn’t be overvalued if they guaranteed a successful trade.
Figure 5.17 illustrates the basic strategies used to capture high IV and to exploit low IV:
|How to Use Implied Volatility|
|When IV is High:|
1) Buy stock, since calls are so expensive
2) Write covered calls
2) Sell naked puts
3) Write bull put spread (credit)
1) Short the stock, since puts are so expensive
2) Sell naked calls
3) Write bear call spread (credit)
|When IV is Low:|
1) Buy calls
2) Buy bull call spread (debit)
1) Buy puts
2) Buy bear put spread (debit)
Note in the table that we generally are buying low volatility and selling high volatility. Of course, being bullish or bearish means that one has formed an opinion about the stock, which would be based upon research and analysis. The following two examples illustrate some of the many ways in which traders can capitalize on high volatility.
The Essex Corp. Example
I bought Essex Corp. (KEYW) in mid-October 2006 at $18.11 and wrote the OTM 2007 FEB 20 Call (PUEBD) for a $1.70 premium (16.41 debit) – all time value. This set up a trade with a duration of 3-½ months if it went to expiration. The 10.4% uncalled return of $1.70 was nearly 3% per month. The if-called return would be $3.59, or 21.9%, which was 6.25% a month. These were much higher premiums than normally were available on Essex. The higher premium, loaded with high IV, was implying potential price volatility in the stock. Figure 5.18 below illustrates the dynamics of this trade.
High-I.V. Covered Call Trade
Essex Corp. (KEYW)
|Buy 100 shares of stock||– $18.11||– $1,811.00|
|Sell 1 FEB 20 Call (10.4%)||+ $ 1.70||+ $ 170.00|
|Net Debit (cost basis)||– $16.41||-$1,641.00|
I felt upon analysis that Essex was not likely to be particularly volatile in actuality, despite the high IV, and made a conscious decision to write a covered call on it in the expectation of one of the following results:
1) the implied volatility spike would collapse, allowing me to buy back the calls more cheaply than I sold them, closing the trade at a nice profit;
2) holding the trade until the approach of expiration causes enough time decay to make an early close profitable; or
3) hold the trade all the way through expiration for a decent return. In my view, 3% a month is decent, 6.25% is fabulous.
It became possible a couple of weeks later to buy back the 20 Call for $3.90 (which contained only $0.34 of time value, down from the original $1.70 of time value) and sell the stock much higher at $23.56, which netted a return of $3.25 (19.8%).
The rise in stock price, from $18.11 to $23.56, did not impede a quick close for a lovely return. This return occurred in only two weeks, due to a lovely combination of the call’s collapse in implied volatility and the stock’s rapid rise. Because IV was much lower for the February calls than for October or November calls, it was necessary to write out to February to get enough time value premium.
Lesson: even if the stock had not made the move (and so delightfully soon) and the trade had gone to expiration, the return still would have been quite acceptable to me on a stock that met my call-writing criteria. Had that not been the case, I essentially would have been gambling on the stock.
The Dendreon Example – a Naked Call
This example will illustrate a radically different approach to selling high IV. Premium was so high on Dendreon in 2007 and the stock was moving due to news pending on its Provenge drug in development.
I speculated that the stock could not hold its price and considered DNDN as a bad covered call play but a good short, puts then being too expensive. A bearish call writer who tried to short the stock found none available to borrow. He instead sold the ITM May 20 Call naked for $8.20 when the stock was $24.35 (close to its high). He repurchased the call at $2.60 when the stock sold off as expected, a pretty good score of $5.60 per share; collapsing IV at work again.
Naked calls normally are written at an OTM strike, above a strong resistance level, in order to provide some breathing room and – hopefully – a bit of warning to close the calls if the stock breaks resistance. Yet this trader sold a deeply ITM call with $3.85 of time value (intrinsic value of only $4.35!) in the next expiration month. The trader’s real risk was a continued move up in the stock; but that was THE only risk. However, the trader won if:
1) implied volatility collapsed, even if the stock remained at that price level, fell or moved up less than the $3.85 of time value received;
2) the stock price collapsed (as it in fact did), which would make it possible to buy back the short calls at a much lower price than for which they were sold; or
3) when time value evaporated close to expiration and the ITM call’s price moved to parity.
Any of these three events would have enabled him to close the short call at a profit. He sold May calls in mid-April to give himself time and room to operate if the stock moved up, even though delta and IV both were lower for the May calls. While implied volatilities for April calls were much higher, they were too close to expiration, which might not have allowed enough time for the expected stock pullback or implied volatility collapse to occur.
From one perspective this trade appears terribly risky, since the stock could, theoretically, have gone to infinity. However, the stock had already spiked hard, and even good news might not have moved it out of the writer’s profitability zone; the trader would only begin taking a loss at $28.20 ($24.35 stock price at entry plus $3.85 of time value received). Also, implied volatility had peaked when these calls were written and was falling, a sign that the spike in stock price was out of gas. Implied volatility can be viewed on a chart, just like price action, at websites such as www.iVolatility.com.
The high time value – which made options far too expensive for someone wishing to buy the Dendreon puts – worked in favor of one writing the calls, who instead pocketed the high time value. Such a trade is not a covered call, obviously, and certainly not for the faint-hearted. For the record, a high-volatility trade such as DNDN should not be considered unless the stock appears to be out of gas and the spike in implied volatility appears to have peaked.
One lacking the options approval level to write naked calls nonetheless could have placed a bear call spread (a credit spread) on Dendreon by purchasing a call with a higher strike than the one sold. Because he receives more for selling the lower-strike call than he pays for the higher-strike call, the position creates a net debit upon open. The long call “covers” the short call in a manner of speaking, since it gives the writer the right to buy the stock at a known price.