Something is afoot in Germany.
Call it an uprising — not of disgruntled bulls or bears, mind you, but of something altogether more important to the option savants among us.
Implied volatility.
Think of it as the perception of risk. Curiously, risk is now priced near a two-year high in the iShares MSCI Germany Index Fund (EWG).
Take a gander at the following implied volatility chart for EWG options. Notice how the gold line (which represents implied vol) is at the tippy top of the range? This means option prices have swelled to levels rarely seen for Germany.
With risk perceptions running hot option sellers are demanding more compensation and option buyers are expressing a greater willingness to pay up.
As the aforementioned chart will attest implied volatility spikes are usually an aberration, born to die a quick death brought on by the unbeatable foe of mean reversion.
Whatever is spooking EWG traders will inevitably pass. And the inflated option premiums will soon deflate bringing profits to those short volatility.
Strangling Germany
While the stable of offerings for shorting volatility is broad, the simplest approach is to sell a strangle. Short strangles offer a non-directional approach for those wishing to sidestep the question of EWG’s next directional move.
The short strangle entails selling an out-of-the-money call and an out-of-the-money put. With EWG perched at $28.75, you could sell the Jul $29 call and the Jul $28 put for a net credit of $1.20.
The maximum reward is limited to the initial $1.20 credit and will be captured if EWG sits between $28 and $29 at July expiration. While that may seem like a narrow profit range, keep in mind that’s the zone where you capture the maximum profit.
By adding the $1.20 credit to the $29 call strike or subtracting it from the $28 put strike you can calculate your breakeven points. At $30.20 and $26.80, your profit range is fairly wide for an ETF like EWG.
The maximum risk is theoretically unlimited due to the short call component. To reduce the loss consider exiting if EWG breaks aggressively outside of the profit range.
At the time of this writing Tyler Craig owned short strangles on EWG.
