Watch volatility into news events
Chris McKhann | [email protected]
If you have a definite view of what you think will happen to a stock after a market-moving development, you can buy options to take advantage of their leverage. So if you are bullish you buy a call, bearish you buy a put.
This gives you a limited-risk position, and you can make multiples of the return of the underlying stock if it goes in the right direction. For example, if the stock moves 5 percent, you can make a 100 percent return--or better--on your investment.
But if you are like me and have realized that you can't predict stock moves this accurately, you can open a trade designed to profit regardless of the direction of the shares, such buying a call AND a put in a straddle or strangle position. That seems like a great play before quarterly results or other expected events, such as product announcements and decisions on pharmaceuticals by the Food and Drug Administration.
There is, of course, a catch: This strategy is widely known and used, so demand for buying options goes up before a quarterly report. That, in turn, drives up the option's premium.
And while the timing of such announcements might be known, the results are not (at least not to us mere--and ethical--mortals). That unknowability is also priced into the option's premium. Practically speaking, this means that options are almost always overpriced going into earnings releases or other events.
We saw a good example of this earlier this month in a trade involving homebuilder Hovnanian. The average implied volatility for HOV is 47 percent. The January 2015 5 calls that were trading at the time had an implied volatility of 50 percent, which is well above the stock's 20-day historical volatility 29 percent. And that metric hasn't been above 50 percent since the lows of July.
From this perspective, those calls appeared very expensive. The trader in question wasn't buying those calls, however--he was selling them. This large player sold 5,000 of those calls and then bought 300,000 shares of HOV, creating an overall position that is delta-neutral and looking for lower volatility than that implied by the options. (This is much like selling a straddle and has a very similar payoff diagram.)
So if options are typically overpriced going into earnings and the pros are using short-volatility strategies to profit, should we do the same? The basic answer is no, because the risk is too great. If the straddle is overpriced 5 out of 6 times, you will make money 5 times and get crushed on the 6th.
Not only that, but you can lose more in that last trade than you did in the first five combined. Therein lies the downside of the nice leverage afforded by options. But there are advanced strategies that do allow you to position for lower volatility with less risk.
Iron condors, calendar spreads, and double diagonals are all strategies that can be used to profit from such situations. And despite their crazy-sounding names, these trades are not particularly difficult to learn if you take the time.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter of Dec. 4.)