If someone wants to trade options, they must understand volatility. It is the only function of an options price that the marketplace does not already know when the option is trading.
This is what creates a marketplace for options. The market place trades prices on options back and forth trying to find the right price of the volatility of the particular option. The prices options trade at actually produce the volatility that is commonly quoted, called implied volatility.
Implied volatility is just that, volatility implied by the price of the options. It is an output, NOT an input as is commonly believed. This could be why it is misrepresented, misunderstood or misquoted so frequently by the talking heads. Traders that do not know better, love to proclaim its predictive powers. I think that is the most laughable part, because implied volatility is wrong far more often than it is right.
I think the best place to find the inaccuracy of implied volatility is in the earnings of stocks.
RIMM Implied Volatility Leads Traders Astray
Research In Motion (RIMM) announced earnings last night, and I am going to take a look at what the market was predicting and what actually happened.
There have been a lot of bad things happening for RIMM lately; most recently, Apple (AAPL) announcing the iPhone would be coming to the Verizon (VZ) network. Traders were apparently worried about RIMM’s earnings, as well as what might be said on its earning conference call. This produced buyers of RIMM options. Traders who wanted to be long the stock but feared the downside bought calls in lieu of stock, or bought puts to protect a long position. This demand raised prices in the RIMM at-the-money (ATM) straddle, which in turn raised implied volatility.
To compare how much the straddle was up, I am going to look at the March ATM straddle with 16 days to expiation. RIMM options typically trade around a 30-35 implied volatility in non-earnings months. On Wednesday’s close, the March 70 straddle (the ATM straddle at the time) was priced at about $3.80, a little over 5% of the value of the stock at the time. This produced an implied volatility of about 31%.
A straddle value of $3.80 means that the surrounding strikes, while still carrying some value, are for the most part not in play. This is confirmed in the values of the 65 and 75 strike, each being worth less than 50 cents respectively.
Yesterday on the close, the RIMM April 75 straddle traded at $7.30. This was almost twice the value of the March straddle and just under 10% of the value of RIMM. This increase in straddle price produced an implied volatility of 56.5%.
Knowing what we know about RIMM implied volatility, once earnings come out for RIMM, regardless of the move, RIMM implied volatility will likely revert back to its mean of about 30%-35%. This also means that only one strike will be in play after the announcement, because the strikes that are not at the money will have little or no premium.
Basically, with RIMM trading at $73.97, if the stock doesn’t move away from the 75 strike by at least $6, the straddle will be a big loser.
Now the important part: Was the RIMM straddle properly priced? How correct was the all powerful predictive prowess of implied volatility? Sadly (for straddle owners), implied volatility was wrong. So much for its predictive value.
RIMM dropped just under $4 on the open, well short of the of the $6-$7 move needed to break even.
Implied volatility immediately sold off back down toward RIMM’s mean of about 30%-35%. Thus, the April 75 straddle, even with the $3.97 downward move went from $7.30 on the March 31 close to $5.15 on today’s open. The straddle was a $2.15 loser. As predicted, there was only one strike in play: the 70 strike, which traded at just under $3.80 (sound familiar?). The 75 strike was right around 50 cents, with little or no premium.
This is just one example of implied volatility gone bad. I have seen many a guru try to pick market direction, market movement and stock swings based on implied volatility. If traders remember that the implied volatility of an option is an output based on the markets best guess of price or, in this case, the markets fear of price movements, traders may be able to cut through the hype of the talking heads on TV or the services that claim to be able to guess movement based on implied volatility.
Understanding what option volatility really is will help traders to be savvy instead of fools (April Fools?).
Related Articles:
- 5 Option Trades on Hot Takeover Rumors
- Bet Your Bottom Dollar on FDO Earnings
- Top 6 Stocks for April
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