The Volatility Wind

by Bill Burton on October 21, 2011

Bicyclist in a Headwind
All bicycle riders recognize the advantage of having the wind at your back. If you can arrange your route to take advantage of this boost, it makes life infinitely easier than wrestling the breeze in your face for the journey.

In the world of options, the headwinds can come as the result of three factors-implied volatility, time to expiration, and price of the underlying instrument. The probability of a successful trade is dramatically improved if the trader can put one or more of these factors at his back.

I thought that I would discuss some concepts to keep in mind when considering trade structures. There’s no sense in needlessly fighting a headwind.

The effect of implied volatility is the most frequently overlooked factor when traders consider structuring a trade. Remember from our recent anatomy lesson that this factor impacts the extrinsic (time) component of option premium. In the case of out-of-the-money options, this extrinsic component represents the entirety of the premium.

One of the important physiologic traits of implied volatility is that it rises in times of perceived future price uncertainty and almost always returns to its historic mean once the perception of an impending potential major price movement has resolved.

It is this ebb and flow of volatility that can provide a headwind or tailwind. As an example, consider the weekly options of AMZN expiring next Friday following release of earnings on Tuesday. These options have a dramatically elevated implied volatility reflective of the potential realized price volatility that will follow earnings release.

Specific trade structures can be selected to respond negatively, positively, or not at all to the decrease in implied volatility that will inevitably follow the earnings release. In œoptionspeak, these represent the categories of vega positive, vega negative, and vega neutral option positions.

The œwind in your face trade would be, for example, for the bullish trader to buy the weekly out-of-the-money $235 strike with AMZN currently trading at $233.23. This option can be bought for $9.50 or so as I type; it consists entirely of time (extrinsic) premium at an implied volatility of 70.1%.

Within the recent past, AMZN has traded at 45% implied volatility. Assuming the bullish thesis is correct, the trader must first overcome the inevitable headwind of collapsing volatility before reaping any rewards that could result from the correct price thesis.

As an example of the œwind at your back trade, the weekly 230/240/260 call butterfly, a vega negative trade can be purchased for $2.24. It is profitable between the range of $232.25 and $247.74 at next Friday’s expiration. It benefits from decreases in implied volatility prior to the Friday expiration- a extremely high probability event if the expected bullish scenario plays out.

The third scenario, I don’t want to worry about the wind, just the price could be executed by selling the weekly 230/235 put credit spread. This spread has no significant exposure to volatility and its success is dependent almost exclusively on maintaining price above $235 by next Friday’s expiration.

The purpose of today’s blog is not to attempt to give recommendations for a specific trade. My intention is to call the trader’s attention to the impact of implied volatility to the probability of success of an option trade. Failure to understand the current position of implied volatility within its relevant historical framework for the specific underlying and to construct trades accordingly represents a major source of error for many traders.

Plan your trades to take advantage of the tailwinds. Save your energy for the unforeseen uphill slopes.

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