The value of options depends on more than just the price of their underlying assets. This is what gives options a unique character among all tradable instruments. Whether we believe that the price of an asset will go up, down, sideways, or even if we have no opinion at all about price movement, there are option strategies that we can use.
The main determinants of option prices are a) the current price of the underlying asset, in relation to the strike price of the option; b) how much time remains in the option’s life; and c) how fast option buyers and sellers expect the underlying asset’s price to move.
All other things being equal, assets whose prices move faster have more expensive options. And, for a given asset, if expectations for its price rate of change increase, prices for its options will increase, even if the underlying price has not yet moved at all. The reverse is also true – an underlying that is expected to slow down will see its option prices decrease. Implied volatility is the name we give to this variability in option prices due to expectations. By paying higher prices for options, people imply that they expect the underlying to move faster, or vice versa.
Implied volatility (IV) is expressed in terms of an “expected” annual percentage rate of change. “Expected” is in quotes, because it’s the rate of change that would have to happen in the future for its actual option prices to make sense. IV varies by asset – as of this writing, the IV of the S&P 500 is 14%; that of the Russell 2000 is 19%, and that of a very volatile stock, RVBD, is 77%.
IV is constantly changing for every asset. When it gets abnormally high or low for that asset, the best bet is that it will go back to normal (revert to the mean) before long. We can profit from a situation where IV is extremely low or high in a few different ways. As we think about them, we must bear in mind that IV affects only the time value (extrinsic value) of options. When we buy time value, we are “buying” implied volatility.
If IV is very high, we can use strategies that involve selling large amounts of time value. If IV then goes down, the time value in these options will deflate, and we can buy back the short options for a lower price (or not at all if the options become worthless). These strategies include selling at-the-money (ATM) puts (if we have a bullish price outlook); selling bear call spreads with the short strike ATM (if we have a bearish outlook); or selling iron condors (if we are neutral as to price, but believe that we can identify a likely price range).
If IV is very low, we can profit from its expected rise back toward the mean, by buying large amounts of time value. Strategies would include (among others) buying long-term ATM calls (if bullish) or puts (if bearish); or long-term straddles or strangles if neutral as to price. Why “long-term”? Because all that time value that we are buying, in hopes that it gets pumped when IV increases, is meanwhile melting away day by day. This “melting” process is very slow when an option has many months to go. It increases at an ever-accelerating rate as expiration approaches. If we buy options with several months to go, and plan to sell them while they still have at least two months to go, we are not really buying all that time value – we are just renting it. If increasing IV pumps up the time value faster than time decay takes it away while we own it, we’ll profit. If not, we’ll sell it anyway before its decline becomes too fast.
In our Professional Options Trader class and our Proactive Investor class, we take a methodical approach to identifying our opportunities, which in broad outline is this. For a given asset:
a) What is my outlook as to price – bullish, bearish, neutral and quiet, or neutral but volatile?
b) What is my outlook as to implied volatility – based on its current level vs its history, do I expect IV to increase, decrease, remain stable, or do I have no idea?
c) With this price/IV combination, which strategy should I use?
Once you know the difference between a bullish strategy, a bearish one and a price-neutral one; and also what strategies involve buying time value vs selling it, the answer to question c) is clear.
As of October 2, 2012, the implied volatility of SPY, the exchange-traded fund representing the S&P 500 index, was near multi-year lows. A reversion to the mean in IV would mean a substantial increase in IV. For this benchmark index, and therefore for most stocks IV was more likely to increase than to decrease in the near term. As to price, the S&P was sitting almost exactly on its 20-day moving average, with no clear direction.
So, with a neutral price outlook and an expectation of increasing IV, what to do?
One answer would be a straddle – buying both puts and calls at the nearest strike price to the closing price of $145.09. The March 2013 145 straddles could be bought for around $12.71 ($5.73 for the calls and $6.98 for the puts). The plan would be to hold these through the election and into the November expiration on 11/16. If price moved a great deal in either direction, or if IV went back to a more “normal” level, or both, this strategy would be profitable. Meanwhile, if neither of these things happened, and both price and IV remained static, it would lose about $2.00 ($200 per straddle), or around 15% of its value. The loss could be higher than that, if price remained static and IV went even lower than these multi-year lows, which we consider unlikely.
How will this work out? We’ll monitor it and let you know. We do know that we have a position with limited risk and unlimited profit, and one which will pay us well if our outlook for IV proves correct.
For comments or questions on this article, contact me at firstname.lastname@example.org