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Ask Trader Guy: Volatility Crushes and Working an Order

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January 1, 2014
Ask Trader Guy: options spreads and stock dividends
Fredrik Broden

Q: Hey, Trader Guy! What does “vol crush” mean?

A: That’s short-hand for “volatility crush,” and it refers to when implied volatility drops suddenly after, say, a news event like an earnings announcement. A lot of times you’ll see the implied volatility of options increase ahead of upcoming news when there’s a lot of uncertainty about what might happen. When the news comes out, the uncertainty is reduced, and vol gets crushed.

Q: Hey, Trader Guy! Sometimes I hear traders talk about “odds” and “probabilities.” What’s the difference?

A: Odds are a ratio of numbers, like 2 to 1, or 3 to 1. Odds refer to the number of times you can lose before you win one time, or the money you can be paid if you win a bet. So, guessing the day of the week could be described as having 6 to 1 odds against. If you “take” the odds, you’re betting 1, to win 6, that you can guess the day of the week correctly. “Laying” the odds is a bet where you bet 6 to win 1. Odds and probabilities are the same concept, but in different forms. Probabilities are a percentage of the times something occurs, over the total number of occurrences. So, the probability of guessing the day of the week is 1/7, or 14.28%. You can convert odds to probabilities, and vice versa. To convert a probability to odds, take the probability and divide it by 1, minus the probability. To convert odds to probability, divide the odds by 1, plus the odds.

Q: Hey, Trader Guy! When I’m working a limit order for an option spread at the mid-price and not getting filled, how long should I keep working it before I change the price or just give up?

A: It’s hard to give real guidelines about how long you should work a limit order because each case is unique. But assuming two things—one, you’re trading a liquid option that has a decent level of trading activity, and two, the price of the underlying hasn’t changed which would change the value of the option spread, I think a good rule of thumb is to give a limit order about 60 minutes to see if it gets filled at the midprice, which is just the average of the bid and ask prices. If it’s not filled by that time, you could change the limit price either higher (for a buy order) or lower (for a sell order) but not by too much, maybe .01 if the options are trading in penny increments. You don’t want to give up too much slippage to fair value. If changing the limit price by .01 doesn’t get it filled in a few minutes, I’d cancel and look for a new trade. Sometimes you need to take your ball and go play in a different field.

Q: Hey, Trader Guy! Stock A is $50 and pays a dividend, stock B is $50 and doesn’t pay a dividend. All things being equal, why are Stock A’s calls cheaper than Stock B’s?

A: These 3 words— cost of carry—will answer 99% of the toughest questions in the world. “What’s for dinner?” Cost of carry. Where’s the dog?” Cost of carry. “Does this make me look fat?” Cost of carry. And it answers this one, too. Think of a call as an alternative to long stock. If you buy stock, there’s a cost to carry it in the form of interest paid to borrow money to buy it, or interest lost on the cash you use to buy it. A call has to factor that cost of carry into its value as an alternative to the long stock. If the stock pays a dividend, the amount of the dividend may partially offset, wholly offset, or more than offset the interest part of the cost of carry. So, the call on a dividend- paying stock is a little bit less expensive because of the reduced cost of carry.

Q: Hey, Trader Guy! I’m betting my college roommates a case of beer on this answer. If Superman can make the Earth spin in reverse and make time decay on long options positive, could Flash get decay negative again by speeding up the expiration cycle?

A: Yes.