Currently the implied volatility levels in the stock market are much higher than they have been for quite some time. What does this mean for our option trading?
One of the main factors in the profitability of our option trades is the “inflatedness” of the prices of the options. When the consensus of option traders is that stock prices will move rapidly, then the prices of options will be inflated. We say that “implied volatility” is at a high level. At such times, as a general rule we want to use options strategies in which we sell options short. We then hope to buy them back later at lower prices, if we have to buy them back at all.
In times when option prices are deflated (implied volatility at a low reading), we use different strategies. We buy options rather than selling them short, in hopes that they will re-inflate to more normal levels. This deflation and re-inflation of option prices happens in cycles. Those cycles are related only loosely to the up-and-down cycles in the prices of stocks themselves. It is quite possible that option prices are deflated while stock prices themselves are inflated, and vice versa.
So at all times, we must gauge whether volatility is high or low, since this determines whether we want to be a buyer of options or a short seller.
As stated above, the usual measure of the “inflatedness” of options is a calculation called implied volatility, or IV. To somewhat oversimplify it, IV is calculated based on the prices at which options are trading; and represents the expected annualized rate of change in the stock price.
An implied volatility reading of 16% on a two-month option, for example, means that based on the price that its buyers are paying today, they expect the stock to move over the next two months in a range that would, if it continued for a year, be 16% wide ($16 for a $100 stock). IV is separately calculated for every option on a stock, and the separate values are then averaged together to get an aggregate implied volatility level for the stock as a whole.
OK. So high IV equals expensive options, and low IV equals cheap options. The next question, then, is – high or low compared to what? The answer is, compared to past history. Which leads to another question – how much history?
Below is a price chart of SPY, the exchange-traded fund that tracks the US stock market benchmark, the Standard and Poor’s 500 Index:
Figure 1 – SPY weekly price chart, with Implied Volatility and ATR as a percentage of price
The above chart shows activity for about the last year. The red line at the bottom is Implied Volatility. Its reading as of October 9, 2014 was about 15%, up from 9.6% just a few weeks ago in July. This means that options are now quite a bit more expensive now than they were then. So, should we now be selling options short?
By the way, the above question has nothing to do with whether we think stock prices will go up or down. If we do decide to be short options because of high volatility, then we will either decide to sell calls if we’re bearish, or to sell puts if we’re bullish.
Now let’s back out a few years for a wider perspective:
Figure 2 – SPY weekly price chart 2008-2014, with Implied Volatility
Notice that the current IV reading of 15%, while pretty high for the last year, is nowhere near the levels that occurred in previous major drops in 2011 when it reached 39%, 2010 (39%) and worst of all 2008 (67%). By the way, these figures represent weekly closing values. In 2008 the intraday high for IV on the SPY was over 90%.
So it’s clear here that a high reading of IV now doesn’t necessarily mean that IV can’t go even higher.
What if it does? If you have sold options short because you thought IV was high, and IV then goes much higher, does that mean you will have large losses?
Maybe, but not necessarily. It is certainly true that increasing IV will in fact push up the price of the options that you sold short, in the short term. But the portion of the options’ value that is affected by IV is time value. When the option comes to its expiration day, it will have no time value – it will have only its intrinsic value. That intrinsic value will be zero if the option is out of the money at that time.
For example, say that you sold the October SPY 186 puts short on October 9 at $.50. These puts would expire eight days later on Friday, October 17. By the way, THIS IS NOT A RECOMMENDATION. If you did sell these, you would have received $50 per contract.
Now let’s say that October 10 was another bloodbath like the 9th, and SPY were to drop by another $4.00, to $192.75. Meanwhile, say the drop in stock prices made option traders more nervous, and the implied volatility level rose all the way to its 2010/2011 high of 39%. On Friday the 10th, the puts that you had sold the previous day at $.50 per share would then be around $2.90 per share. If you were to close out the trade at that point by buying to close the puts at $2.90, it would be for a loss of about $2.40 per share, or $240 per contract.
BUT – at that SPY price of $188.75, the 186 puts would still be out of the money. That would remain true unless SPY were to drop all the way below $186 in the following week. As long as SPY were to remain above the $186 put strike price, and you did not close out the short put position, you would still eventually make your $50 per contract. This is because the puts would still expire worthless, as long as they were out of the money at expiration day.
So whether they temporarily had a time value of fifty cents, three dollars, or three hundred dollars, at expiration they would have no time value. As long as SPY remained above $186, the options would have no intrinsic value either, and expire with no value at all. You would keep your original $50 per contract.
Don’t get me wrong. You can have disastrous losses when selling puts. That happens when the stock does in fact drop below the put strike price by a large amount. In the above scenario, say that SPY were to have another week like the one ending October 10, 2008 (exactly six years ago), when it dropped 19.8%. A similar slide from $188.75 would take the SPY down to about $151. At that SPY price, the $186 puts would be in the money by $35 per share. They would have intrinsic value equal to that $35 amount, even though at expiration they would have no time value. The seller of the 186 puts would have to pay that $35 per share one way or another, and would have a loss of $34.50 per share, or $3450 per contract. This is about seventy times the original hoped-for $50 profit.
Could the put sellers here have defended themselves from such a disaster? Yes, in fact they could, by hedging their short put positions. That is a subject for a future article.
For today, in summary:
When deciding whether IV is high or low, the last year is a useful guide; but don’t assume that IV can’t go much higher than that range.
The best defense against increasing IV in a short option position is proper selection of the option strikes in the first place. If the short options expire worthless, it won’t matter what IV did.
Be aware of the worst case scenario and what effect that would have. If you can’t afford it, don’t do it. Consider hedging, or using a different strategy with less risk.
Russ Allen can be contacted on this link: Russ Allen