Tuesday, July 28, 2009

Profiting from Implied Volatility

The most common view of those that are unfamiliar with options trading is that it is “RISKY.” One of the main reasons for this is the changes in Implied Volatility can alter the option’s price in a way that is too often misunderstood. Anyone that has entered a straddle the day before earnings only to have no significant move up or down in the stock price, more than likely has witnessed a drop in their options value the next day…It would be safe to say that the finger of blame could be pointing in the direction of implied volatility and how rapidly it can decrease.

Understanding and controlling implied volatility is critical to any option trader’s success. One way to manage it is to buy options between earnings periods when implied volatility is often closer to the low of its range than the high. Since part of an options price will increase/decrease due to changes in the implied volatility as represented by its VEGA amount. The relationship is for every 1% increase/decrease in implied volatility the options value will increase/decrease by the VEGA amount. Therefore the result from a 10% increase/decrease in implied volatility could mean a great return or an outstanding loss of invested capital.

How am I profiting? By buying my options when implied volatility is low, usually about 6 weeks before an earnings event… If the stock moves, that is just a bonus! On the other hand I will never make money with the use of options if I don’t know how and when to exit. Having a primary and secondary exit plan is essential to consistent profits when trading.

When should I exit in this type of situation? The day before earnings when IV is at a peak!

Here are some stocks between earnings with low Implied Volatility:

  • Research in Motion (RIMM), maker of the Blackberry is a good candidate at present. The company is not scheduled to releases earnings again until September.
  • Apple Computers (AAPL) who is now a competitor of RIMM doesn’t have an earnings announcement again until October.
  • Pharmaceutical company Merck (MRK) is in between earnings and doesn’t have another announcement until October.
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