How to Benefit From Implied Volatility Without an Expensive Data Service
Options traders know that volatility is useful. In fact, it is one of the most important components in standard options pricing formulas. Before discussing how to use volatility, it is important to define exactly which volatility we are talking about.
For options traders, two types of volatility are important. Historic volatility is based on what the price of the option has done in the past, Implied volatility is the estimated volatility of the option’s price in the future. Implied volatility is the more important of the two in determining the option’s value.
We usually see implied volatility rise when the stock is declining or when the broad stock market is bearish. Implied volatility is expected to decline when prices rise. These beliefs are logical.
When prices fall, the demand for put options tends to increase. This leads to an increase in the price of the puts. Because of the way implied volatility is calculated, this sequence of events will result in higher volatility. In some ways, it is just the way the math works.
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Now, those facts are logical and widely accepted. But, the reality in the market is a little more expansive. We usually see volatility rise when prices spike up as well. This is also logical.
As prices rise suddenly and sharply, demand for puts is likely to increase. This is because some traders will buy put options expecting the price to reverse. They would benefit from a decline in the price of the stock as their puts rise in value.
As prices rise rapidly, other traders will consider put options as protection against a loss. This will allow them to lock in some gains even if the price reverses.
In the markets, the truth is we tend to see implied volatility increase whether the price of a stock moves up or down.
Market Data Proves Volatility Also Rises When Prices Rise
Using a subscription data service, we scanned a list of stocks with the highest implied volatility. There are different ways to calculate this indicator so lists can and do vary depending on where and when they are accessed.
On our list, options on Blackberry Limited (Nasdaq: BBRY) were on top. A quick glance at the chart indicates the increased volatility has been to the upside.
The information about implied volatility is useful but may not be available to all investors. We do know that implied volatility is just one way to measure volatility. More accessible indicators including the average true range (ATR) and Bollinger BandWidth also measure volatility. We have added Bollinger Bands and Bollinger BandWidth to the next chart.
Bollinger BandWidth is an indicator that is calculated from Bollinger Bands. In his book, Bollinger on Bollinger Bands, John Bollinger explains that BandWidth measures the size of the difference between the upper band and the lower band.
On the chart, we can see that BandWidth decreases as Bollinger Bands narrow. The Bandwidth then increases as Bollinger Bands widen. This is a visual depiction of volatility. It is also a mathematical description of volatility.
Bollinger Bands are calculated using standard deviations. In finance, for many applications standard deviations are synonymous with volatility. This means expanding Bollinger Bands will always indicate rising volatility and BandWidth can be used to measure this process.
Returning to the chart, we can see that BandWidth is high now. That indicates volatility and options premiums should also be high. BandWidth appears to be leveling off and should then decline. This indicates now could be an ideal time to sell volatility.
Selling volatility when it is high allows traders to benefit from the eventual decline. As volatility declines, options premiums should also decline. Sellers benefit from the decline in premium and profit directly from this market action.*
High Volatility Can Benefit Options Traders
Because high volatility results in high options prices, traders can benefit from high volatility with strategies that sell options. It will always be important to minimize risk when selling options but that can be done with a number of spread strategies.
A short condor strategy is one to benefit from a decline in volatility. The risk and payoff for this strategy are shown in next chart which is from The Options Industry Council website.
The diagram shows that the trade profits if the stock remains in a trading range. Losses are limited and the potential gains are limited to the amount of premium received when the trade is opened.
To open a short condor trade, the investor will need to sell a call option while buying another call with a higher exercise price, while selling a put option and buying another put with a lower exercise price. There are strict requirements as to what options contracts we will need to use to create a condor.
We will want the call exercise prices to be above the current stock price and the put exercise prices will need to be below the current price of the stock. We will need the distance between the call exercise prices to be equal to the distance between the put exercise prices, and all of the options will have the same expiration date.
Trading a Short Condor in BBRY
Now that we know the requirements, let’s walk through which options we will use in the trade.
Blackberry closed on Thursday at $11.06. BBRY is an active stock with a number of available options contracts, available in increments of $0.50. Given the closing price, we will need calls with an exercise price of at least $11.50 and put options with exercise prices below $10.50.
There are weekly options available on BBRY. By limiting the amount of time to expiration, we reduce the risk on the trade. Allowing more time to expiration gives the stock more time to make a large move. Using a short time to expiration also maximizes our use of capital.
For traders, capital is a limited resource. It may be best to take small profits frequently, compounding gains rapidly, rather than pursuing large profit opportunities that can take months to achieve. For BBRY, options expiring in about a week, with an expiration date of June 30, provide the opportunity for a short term gain.
Now, we need to select the appropriate options. To do that, we need to look at the maximum risk. For this strategy, the maximum loss is the difference between the exercise prices of the calls less the amount of premium received. Remember that the difference in exercise price of the put options will be equal to the difference in the exercise prices of the calls.
For this example, we will use a difference of $2 between strike prices. You could decrease risk further by using a difference of $1.50, $1 or even $0.50.
With those parameters set, the following trade is set up:
- Long June 30 $13.50 call at $0.08
- Short June 30 $11.50 call at $0.45
- Short June 30 $10.50 put at $0.35
- Long June 30 $8.50 put at $0.05
This trade results in a net credit of $0.67. The maximum risk is then $1.33 per contract. The maximum profit is $0.67, the amount of the credit. This is a potential return of about 50% on the amount risked and the trade will only be open for a week.
There are several appealing aspects of this trade. One is that it benefits from selling volatility at a time when volatility appears to be declining. Another is that risk is limited. A third appealing aspect is the fact the potential return is high for a small amount of risk. Finally, the trade is only open for one week. The short time frame allows for potentially rapidly compounding gains.
Short condors are just one way to benefit from high volatility. But, they can provide relatively large percentage returns for small dollar amounts of risk and could be valuable for traders looking to grow their wealth.