Whereas many option traders focus exclusively on trading volatility, I like to combine it with fundamental and technical analysis in order to get any edge I can. Yes it may be extra work for each trade/investment you put on but I feel in the end, it will certainly show up in your profit and loss statement. Volatility is simply a measure on how much the price of a particular financial instrument is expected to change over time. Some stocks are extremely volatile and have wide trading ranges. Well option sellers get paid handsomely to trade these instruments due to the perceived risk involved in these respective trades. That is where implied volatility comes in as it is more forward looking. So for example take a stock like Apple (NYSE:AAPL) trading with an implied volatility of 25%. What this means is that its present stock price is predicted to move at max either 25% down from its current price or 25% north of its present price over the next 12 months. The higher this implied volatility number, the more expensive the options will be. One can really see at earnings announcements how options prices get inflated because there is far more movement being priced into the options at these times of the year.
When companies announce earnings, you have far more option buying taking place due to the potential expected move of the underlying. This buying spikes the prices of option premium which benefits option sellers. Furthermore implied volatility (future expected range) is almost always higher than the historic volatility (past trading range) which gives option sellers another benefit here. Moreover volatility is mean reverting meaning that it will eventually return to its mean or average. This again can be seen clearly after earnings have been announced when there always is a large contraction in implied volatility. Why? Because the potential post earnings move in the underlying (whether it happened or not) is now out of the way meaning there isn’t an imminent catalyst on the horizon that can move the stock forward.
Why do traders/investors need to know about implied volatility and when it is trading at extreme highs or lows relative to itself? This metric is probably what separates the normal traders from the advanced traders. Imagine selling premium (assuming a long position) on a fundamentally sound stock which was trading on the cheap (valuation wise) but the option premium wasn’t that high due to the stock at that time trading with low implied volatility. Straight away (especially if the option expires in only a month or so), the trader is at a disadvantage because the option premium was sold when implied volatility on the underlying was trading near the lows of its range. Now compare this with a strict volatility trade – i.e, not a trade based on fundamentals or technicals but strict volatility. The trader here only is looking for a contraction in volatility and is not concerned about the price or fundamental nature of the stock. What we want to do is combine the two. Combine high implied volatility with stocks that have excellent fundamentals. This gives us the best opportunity for both short term and long term gains.
Our strategy is to sell premium on quality stocks that are trading well below their historic valuations and rinse ,wash and repeat. Quality stocks can in fact remain cheap for a long time and when they do, we want to be aggressively selling premium against these positions. The initial phase where stocks rally out of oversold conditions is where we want to do all of our trading. Once we feel the stock has gotten quite expensive relative to its historic valuations is the point at which we look for greener pastures. Furthermore many times, (once we have earmarked a fundamentally strong stock), these companies will come back into our buy zone either through surprising earnings reports or general market behavior.
Therefore it is essential to monitor implied volatility numbers in order to ascertain when is the best time to sell options (when implied volatility is up near the higher part of its range) and buy (when implied volatility is nearer the lower part of its range). Remember our strategy is to turn over capital quickly and the best way way to do this is to sell option premium when implied volatility is near or at extreme levels.
So what strategies do we use to take advantage of these conditions? Usually we sell naked puts, put spreads and jade lizards to take advantage of high implied volatility. Remember we want to turn over capital as quickly as possible but if a trade goes against us, we use rolling strategies (and can even take possession of stock) at some point as we have the fundamental analysis work done on the underlyings. I will go through this strategies in later posts.