Know Your Options: Buying Volatility When It’s Cheap

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Buy low, sell high. It’s a basic rule of investing everyone’s heard.

What they might not appreciate, however, is how it applies to implied volatility. We’ll examine that today because it may help spare some readers money and hassle.

First, remember that implied volatility is a number showing how much movement the market expects from a given security. The higher it is, the more expensive the options are, and vice versa.

Second, implied volatility tends to fluctuate around events. It rises before something like quarterly results, which can move the stock. And it typically falls after the event. That’s what we want to consider today.

The blue line on the bottom of the chart below shows the implied volatility for retailer Macy’s (M). Notice how it rises before earnings and declines after.

Macy’s (M) chart showing changes in implied volatility.

Say a trader was bullish on M after the last set of numbers in May. He or she could have waited until late in the month for lower implied volatility before buying calls in hope of a rally.

That would decrease their chance of losing money, although there was still risk of losses from a potential decline in the share price.

The other benefit of this technique is that implied volatility increases into the next set of numbers. That can puts some wind at your back in terms of simple price appreciation in the options.

Clients should also understand Delta and Vega before attempting such a trade. These are known as “Greeks” because mathematicians often use Greek letters to represent different parts of an option’s value in their pricing formulas.

  • Delta is sensitivity to the underlying stock’s direction. If call has 0.5 delta and the shares rise $1, the options will appreciate by $0.50. By the way, it works just the opposite with puts, which is why their deltas are expressed as negative numbers.
  • Vega is sensitivity to implied volatility. Say a contract has 0.05 vega and implied volatility increases from 30 to 35 percent. Independent of movement in price, the option’s value will increase by $0.25. That’s 0.05 (vega) X 5 percentage points.

Returning to M, a trader buying calls in late May could have profited from the stock price rising (delta) and implied volatility increasing (vega). Of course, either of those Greeks could have gone against them as well.

In conclusion, there are lots of ways to make or lose money with options. Hopefully this post illustrates one of the ways of the ways calls and puts can options can be used in your own trading.

Disclosure: Options trading may not be suited for all investors.

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David Russell is VP of Content Strategy at TradeStation. Drawing on nearly two decades of experience as a financial journalist and analyst, his background includes equities, emerging markets, fixed-income and derivatives. He previously worked at Bloomberg News, CNBC and E*TRADE Financial. Russell systematically reviews countless global financial headlines and indicators in search of broad tradable trends that present opportunities repeatedly over time. Customers can expect him to keep them appraised of sector leadership, relative strength and the big stories – especially those overlooked by other commentators. He’s also a big fan of generating leverage with options to limit capital at risk.