Alan Ellman, of TheBlueCollarInvestor.com, explores the different conditions that can cause the market to anticipate a significant price change in stocks and ETFs and elevate the implied volatility of the associated options.
Option trading basics teaches us that selling call and put options is actually selling time value. Time value consists mainly of time to expiration stats and the implied volatility (IV) of the underlying security. Since most of us are selling monthly options, the main distinguishing factor in our option prices is the implied volatility…we are selling volatility.
In this article, we will take a look at how implied volatility is impacted by individual stock events and then we will take a broader look as to how implied volatility is influenced by supply and demand for options based on market perception.
Individual Stocks
There are certain events that can cause the market to anticipate a significant price change in our stocks and exchange traded funds (ETFs) and, therefore, elevate the implied volatility of the associated options. The most common of these circumstances are earnings reports, a topic I will never stop discussing because I consider it so important to our ultimate success. Other events, like impending FDA announcements of drug approvals and Federal Reserve announcements (among others) will also elevate implied volatility and, therefore, our option prices. However, higher IV also means greater risk as share value can decline significantly, thereby resulting in substantial losses. This is why a golden rule is to never sell a covered call or put option when there is an upcoming earnings report prior to expiration Friday. Although IV is influenced by a myriad of factors, earnings reports are one of the most common and important, as shown in the chart below, highlighting the volume spikes (as shown by the CBOE Volatility Index or (VIX)) in each of the last four earnings quarters:
Implied volatility and earnings seasons
Click to Enlarge
General Market Perception
Options are used for three major reasons:
- Generating cash flow (that’s us)
- Speculation (betting a stock price will move up or down)
- As a risk management tool (hedging)
Hedging
Institutional investors (mutual funds, hedge funds, banks, and insurance companies) use options to protect their multi-million dollar portfolios. When there is an impression that risk is increasing, there is a greater demand for option hedging (buying puts as an example) and, as a result, prices of these securities will rise. On the other end of the spectrum, when the market is presuming a period of lower volatility, the demand for option protection is lessened and therefore options are sold and prices decline.
Speculation
There is a greater demand for call options as IV increases because shares of stock can be controlled at a much lower cost, and if the trade turns against them, there is less capital risk than if the shares had been purchased. In addition to this, during times of low volatility, speculators will turn to selling options (just like us) to elevate the returns they are not receiving due to the low-implied volatility environment.
Summary
Long option positions are supported by high volatility conditions while short option positions benefit from low volatility situations. Buying and selling options is equivalent to buying and selling volatility.
By Alan Ellman of TheBlueCollarInvestor.com
