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Twisting Out the Volatility Knot

by | Dec 18, 2018 | Bishop's Corner

That was fast.

The Russell 2000, a stock index consisting of small-cap stocks, went into bear market territory yesterday. Despite the strength we’re seeing this morning in the market, there is no denying that volatility has picked up over the last 2-3 months.

And you know what?

I love it.

You see, when market volatility like this spikes, it causes a lot of disruption in the options market. In fact, I’ve been taking advantage of these “volatility shocks”, like you see here:

Why does this happen only to options and never in stocks?

Simple.

Options are priced differently than stocks. When you buy a stock, its price needs to rise for you to make money, and you lose if its price drops. However, price is not the only value used to price an option. For example, factors like time and volatility play a significant role.    

And because of that… you can make insane returns on just the slightest of stock moves.

Traders Rely on Volatility

 

Option traders rely on the “Greeks” to help measure risk and better understand their position. The Greeks allow you to measure how sensitive your profit and loss (PnL) is to changes in factors affecting options prices, such as the stock price, interest rates, and volatility. If this sounds foreign to you, check out this guide that shows you how I use options to accelerate my profits.

Now, “vega” is the option Greek that tells us how volatility affects our position.  

All you really need to understand is- vega measures how sensitive an option’s price is in relation to changes in its option volatility. More specifically, vega reflects how much an option’s price would change for each 1 percentage point move in implied volatility.

Remember, when you’re long an option, that means you’re long vega – it doesn’t matter if it’s puts or calls.

That said, when you are long options, an increase in implied volatility benefits your position. On the other hand, when you open to sell, or write, options, you want implied volatility to fall because it would cause them to lose value.

For example, assume you’re long a call option, and the vega and implied volatility are 0.15 and 30%, respectively.

All else being equal, if the implied volatility jumps to 31%, that call option would increase by 0.15. On the other hand, if implied volatility falls to 29%, that option would drop by 0.15.

Here’s a look at an options chain on Apple Inc. (AAPL).

Take a look at the $160 calls…they have a vega of 0.18. That means if AAPL’s implied volatility increases by 1%, those calls should rise by 18 cents, or $18 – equity options have a multiplier of 100.

Pretty simple if you ask me…

You might be wondering, “Jeff, how can I use this to make money trading options?”

Well, there are a number of ways to use vega to your advantage.

Using Vega to Accelerate Your Profits

Ahead of catalysts events – such as earnings, Federal Reserve Bank meetings, and investor days – volatility tends to rise. This is due to the fact that there’s uncertainty headed into these events. However, once the news is out…volatility drops.

For example, Oracle (ORCL) just reported earnings…the uncertainty is gone, and consequently, the implied volatility dropped by 10.5 percentage points. Now, heading into earnings, ORCL had an implied volatility of 40%. Take note, that implied volatility is typically quoted in annualized terms.

In order to understand it in daily terms, you would divide 40% by the square root of 252 (since there are 252 days in a trading year). So if you divide 40% by 15.87, ORCL was expected to move just over 2.5% the day after its earnings announcement.

Now, with stocks, volatility typically rises when stocks go down…traders rush to buy puts to hedge, and in turn, the rush of put buys causes options to become more expensive due to the increase in demand.

That said, it makes sense to buy options when you feel volatility is low and avoid buying when it’s high. Keep in mind, each stock has its own volatility levels.

For example, a biotech stock is going to be more volatile than a major bank stock. It’s simple, a biotech stock will tend to fluctuate more than a bank stock.

Here’s a look at Tilray Inc. (TLRY) – a pharmaceutical cannabis stock.

On the other hand, look at this daily chart of Bank of America (BAC).

Notice how TLRY’s moves are a lot more exaggerated than BAC…of course, TLRY is a more volatile stock, and therefore, it’s implied volatility will be higher than that of BAC.

Some key takeaways about vega and implied volatility:

  • When you buy options, you are long vega and want volatility to increase…it doesn’t matter whether you’re in puts or calls.
  • Implied volatility rises due to uncertainty and upcoming events, such as earnings, catalyst events like FDA approval date, court hearings, etc.
  • Implied volatility tends to get crushed after a catalyst event because the uncertainty is gone and news is out.

That said, I use this greek and implied volatility levels in my trading strategies all the time…and a lot of the times I’m able to generate 100%+ returns on my trades. Click here to see what I’m talking about…

To YOUR success!

Jeff Bishop

Getting Started

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