Sheridan Options Mentoring Blog

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The Volatility Wind Posted: 21 Oct 2011 09:48 AM PDT All bicycle riders recognize the advantage of having the wind at your back. If you can arrange your route to take advantage of this boost, it makes life infinitely easier than wrestling the breeze in your face for the journey. In the world of options, the headwinds can come as the result of three factors-implied volatility, time to expiration, and price of the underlying instrument. The probability of a successful trade is dramatically improved if the trader can put one or more of these factors at his back. For today's blog I thought that I would discuss some concepts to keep in mind when considering trade structures. There is no sense in needlessly fighting a headwind. The effect of implied volatility is the most frequently overlooked factor when traders consider structuring a trade. Remember from our recent anatomy lesson that this factor impacts the extrinsic (time) component of option premium. In the case of out-of-the-money options, this extrinsic component represents the entirety of the premium. One of the important physiologic traits of implied volatility is that it rises in times of perceived future price uncertainty and almost always returns to its historic mean once the perception of an impending potential major price movement has resolved. It is this ebb and flow of volatility that can provide a headwind or tailwind. As an example, consider the weekly options of AMZN expiring next Friday following release of earnings on Tuesday. These options have a dramatically elevated implied volatility reflective of the potential realized price volatility that will follow earnings release. Specific trade structures can be selected to respond negatively, positively, or not at all to the decrease in implied volatility that will inevitably follow the earnings release. In "optionspeak", these represent the categories of vega positive, vega negative, and vega neutral option positions. The "wind in your face" trade would be, for example, for the bullish trader to buy the weekly out-of-the-money $235 strike with AMZN currently trading at $233.23. This option can be bought for $9.50 or so as I type; it consists entirely of time (extrinsic) premium at an implied volatility of 70.1%.

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