by Tyler Craig | September 19, 2012 11:39 am
While the majority of trading bets are directional in nature, the options market provides a class of trades focusing primarily on volatility. When it comes to trading volatility, the question of which direction takes a backseat to two more important questions: how fast and how far.
Rather than accurately predicting direction, a volatility trade might look to exploit a situation where a stock is poised to move faster and further than currently reflected in option prices, or, alternatively, slower and not as far as the options are discounting.
Click to Enlarge With that in mind, let’s highlight just such an opportunity that might be arising in Riverbed Technology (NASDAQ:RVBD).
During the past week, RVBD has seen its implied volatility jump a quick 17 points from the mid-50s to low-70s. At 71%, implied volatility is sitting in the upper end of its one-year range. Additionally, with 20-day historical volatility at 31%, implied volatility is trading at a whopping 40-point premium.
Of course, the lift in implied vol isn’t occurring in a vacuum. Earnings are set for Oct. 18, and if the last two earnings reactions are any indication, RVBD might be in for a monster gap. But, hey, we’re still a month out, and I think there might be adequate time to enter and exit a volatility play before the earnings boogieman shows up.
While traders could structure a directional play to take advantage of the high implied vol, I’ve selected a trade that removes direction from the equation and is thus a pure play on volatility — the short strangle.
The position is entered by simultaneously selling an out-of-the-money put and an out-of-the-money call in the same expiration month for a net credit, which represents the maximum potential profit. The best-case scenario occurs if the stock remains in between the strike prices of both options, causing them to remain out-of-the-money and thus expire worthless.
Traders could sell the Oct 27 call and the Oct 19 put for a net credit of $1.06 or better.
To avoid the event risk associated with earnings, consider closing the trade the day before earnings at the latest. To minimize risk in the interim, traders might consider closing the short call if the stock reaches $27, or the short put if the stock reaches $19.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
Source URL: http://investorplace.com/2012/09/exploit-high-volatility-before-the-earnings-boogieman-comes/
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