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Market Grudge Match: Enter a Trade Using Volatility or Price?

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October 1, 2015
strategy selection market volatility
Fredrik Broden

When traders look at volatility, they often mine it for clues as to potential stock price or market direction. Kind of like a counter indicator with the idea that when prices rise, volatility goes down. And when prices drop, volatility goes up. So, if volatility (vol) is low, maybe stocks have been overbought and could drop. And when volatility is up, maybe stocks have been oversold and could rally. Sometimes that works, and sometimes not. For instance, we saw consistently higher stock prices in 2014 and 2015, despite persistently low volatility.

If you can’t rely on volatility regarding the direction of stock prices, what good is it? It’s potentially a useful guide, but in context. At the beginning of a trade, volatility is best used to pick the trading strategy for a given opinion regarding what the price of a stock or index might do. Rather than using it to replace your fundamental analysis, charts, or technical studies to determine the potential direction of a stock or index, use it to pick a strategy to speculate on a given direction. During an option strategy’s life, volatility typically impacts a trade’s p/l. However, it’s at the end of the trade where the profit or loss on most options trading strategies depends a lot more on where the stock price goes and not on volatility.

The Myth of Volatility

All things being equal, options values increase when implied vol rises, and decrease when implied vol drops. So, a short option typically loses money when implied vol rises, and makes money when implied vol drops. But the “other things”—like time and stock price— are always changing, too. Let’s examine how those other things can matter more than volatility when it comes to profit and loss.

When vol drops
Say a stock is $100 and your 90 put is worth $1 when the stock’s implied volatility is 35% with 30 days to expiration. You short the put, expecting the stock to either rise or not drop much, as well as the implied vol possibly dropping. Fast-forward to expiration, and the implied volatility of that 90 put is now 0%. You sold the put when its volatility was 35%. So, the short put should be profitable, right?

Actually, if the stock is $85 at expiration and your short 90 put is five points in the money, it’s losing money. You sold it for $1, less transaction costs, and now it’s worth $5. With the stock price at $85, and the 90 put trading for $5 at expiration, the put’s implied volatility is 0% because it doesn’t have any extrinsic value. It’s worth only its intrinsic value (90 – 85) and no more. In this case, the change in vol doesn’t tell the whole story. The price of the stock determined the profit or loss of the short put—not volatility.

When vol rises
Let’s look at that same short put, but assume the stock is still $100 at expiration. That 90 put might be 0.00 bid/0.05 ask. Not completely worthless, but close. So, the 90 put is assumed to have value somewhere between the bid and ask, even at expiration. That would make its implied vol 90% or higher. Say you sold the 90 put at $1, less transaction costs, and it’s now worth $0.025 at expiration. It’s profitable. But the 90 put’s implied volatility rose from 35% to 90%.

How can that be? First, because external factors (time, stock price, etc.) are at work as well, there’s nothing that states a short option loses just because implied volatility rises—no more than it profits when it goes down. In fact, in the last two examples, the change in implied volatility is not what determined the short put’s profit or loss. What did? The stock price. It depended on whether the short put was in or out of the money at expiration. For example, a butterfly spread makes its max profit if the stock is at the short middle- strike price at expiration, regardless of whether volatility is higher or lower. A short strangle makes its max profit if the stock is in between the short strike prices at expiration, because volatility premium ceases to exist when there is no time left.

Now, if we were to look at the profit or loss on that short put before expiration, a big change in volatility could have had a larger influence because the option’s vega—an option’s sensitivity to changes in implied volatility— fluctuates over time. It’s higher with more time to expiration, and lower with less. Remember, vega is how much the theoretical value of an option can change if its implied vol moves up or down 1%. And implied volatility is a measure of the option’s extrinsic (time) value. When an option has even a little extrinsic value, and a low vega close to expiration, its implied vol can be high. Take a look at the Trade page on thinkorswim®—with the “Impl Volatility” column loaded up. Find a far out-of-the money option’s implied vol close to expiration, and it will likely be high.

Volatility = Strategy 

So when does a trade have the most time to expiration? When you put it on. And that’s the time its vega will be highest due to the longer time to expiration. With this in mind, you might take your stock directional cues from charts or technical or fundamental analysis. However, the strategy you use to implement a bullish, bearish, or neutral position should depend on the volatility of the options for the stock or index when you initiate the trade.

For example, if you think the price of a stock will go up, you have some choices on how to trade it. You could buy it. You could buy a call or a call vertical spread. You could short a put or a put vertical spread. Those are all bullish strategies, but they all have different vega. A long call or long call vertical have positive vega. A short put or short put vertical have negative vega. And stock has zero vega.

When you use volatility to determine strategy, not direction, you’re potentially putting its real influence on your side. That might mean shorting options when they’re a bit higher, and buying options when they’re a bit lower.

When vol is high
Again, if volatility is high when you open a trade, options premiums will likely be high, too. Thus, the credits you get for bullish short put or short put vertical trades would likely be higher, too—which translates to a larger potential profit.

When vol is low
When you initiate a trade, low volatility typically means options premiums are relatively low. The debits you pay for bullish long calls or long call verticals are a bit lower—all things being equal—because vol is lower. Buying options for lower debits means your potential risk is lower.

What's High? What's Low?

So how do you determine when volatility is high or low? thinkorswim has a proprietary number—the IV Percentile—available for any stock or index with options. Find it in the Today’s Options Statistics section on the Trade page. (See below.)

guaging volatility

THREE STEPS TO GAUGING VOLATILITY

For illustrative purposes only.

The IV Percentile compares the current implied volatility to its 52-week high and low. An IV Percentile at 100% means the current implied volatility is at its 52-week high. An IV Percentile at 0% means the current implied volatility is at its 52-week low. Now, there’s no guarantee that high vol won’t go higher, or low volatility lower. But when you see the IV Percentile over 80%, for example, it means implied vol is higher than it has been over the past year, and options prices are relatively high. When the IV Percentile is under 20%, for example, options prices are relatively low.

Say you’re bearish on a stock. Take a look at the IV Percentile. Over 80%? Consider a bearish short call vertical that has negative vega. Under 20%? Consider a long put vertical that has positive vega. Near 50%? You might sell an out-of-the-money call vertical if you’re feeling less confident about your opinion on direction, or buy an at-the-money put vertical if you’re feeling more confident.

Basing strategy on IV Percentile or a judgment on volatility doesn’t guarantee your trading decisions will be profitable. But it does potentially give your actions a fighting chance by having volatility work for, rather than against, your chosen strategy. And once you put the trade on, focus on where the stock price actually is, while tracking implied vol changes as icing on the cake.

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