#394 - What's The Point Of Trading High Implied Volatility When The Stock Is Making Even Larger Moves?

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Oct 21, 20185m
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#394 - What's The Point Of Trading High Implied Volatility When The Stock Is Making Even Larger Moves?
Oct 21 '185m
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Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we’re going to answer the question, “What's the point of trading high implied volatility when the stock is making even larger moves?” This question came from another one of our members and the underlying theme here is really just this idea of – Why do we trade options when high implied volatility is present in the market? Doesn't high implied volatility then reflect that the stock is going to make this large move or this massive move? Why are we stepping in front of a freight train (for lack of a better term) and trying to trade options and sell premium hoping that the stock is going to stay contained when everyone is betting on these big moves? And the reason that we do that is because what we’ve consistently seen not only through our research, but you can also check other sources and other data providers, but when we see high implied volatility situations, situations where a stock is expected to make a very, very large move and we’re talking the upper echelon of implied volatility ranges, the 70% to 100% IV rank or IV percentile ranges, when a stock is expected to have these wild, wild moves, option premiums go through the roof. And so, what we see is we see that traders are expecting a big move and therefore they bid up all option premiums on both sides, both calls and puts looking for this big move, but the catch is that it generally doesn't happen as big as the market expected. Now, this doesn't mean that the stock won't move. In most cases, it probably will make a pretty big move, but even that big move is going to be more than compensated by the option premium that you might have been able to sell by selling strategies around where the stock is trading.

To use two examples of this and you can check them out from just like recent charting here, GDX is a great example of this, same thing with EWZ which we’re going through right now actually at the time I’m recording this. GDX back in early August had a massive decline in price and as a result, implied volatility went from basically the 20th percentile up to around the 88th percentile. Now, at that time, we sold a lot of option contracts in GDX because volatility shot up through the roof and had this huge movement. Option premiums were blowing up in the gold market, and so, we sold a lot of options. Now, fast-forward nearly two months and GDX has no joke (right now as I’m looking at this on my chart) has moved dead sideways at the end of two months. Now, there's been some fluctuations back and forth, but the price that GDX was at when implied volatility was at 88 and the price that GDX is at now is the same price. And there's been a little bit of fluctuation between there, but basically, what’s happened is that GDX has really not moved anywhere over the last two months, although traders expected GDX to have a $3 or $4 move, but it's moved nowhere. And so, that's the over-expectation that we see all the time in pricing. Now, granted this happens a lot with GDX and SMH and all these other ones. It doesn’t happen all the time. I’m not here to say that it happens every single time. But the vast majority of the time, you have a much better probability of success. The odds are heavily tilted in your favor to be selling premium during these time periods.

The other example here is EWZ. EWZ had recently gone through an election and right before that election, option premiums were about $5 to trade a straddle. Even though the stock was trading at around 36, you could collect about a $5 premium for trading the at the money straddle. And so, that basically would’ve put your breakeven point around 41 ish depending on where you traded it. Well, fast-forward and we got the election news out of Brazil and whatever the results were and I honestly don’t even know what the results were, but it caused the market to move and the market had a big move. It was up almost $3.5. Now, most people were freaking out because this is a big move in EWZ. It gapped higher. It had a lot of volume, a lot of liquidity coming into the market, but it still wasn't enough to cover the difference in the option premium, so traders were expecting an even bigger move in EWZ. And although we got a big move, for sure, it was a big move for a small ETF stock like this, it was definitely not the big move that we expected. Again, the reason that we trade implied volatility when it's high even though we’re expecting large moves is because the option premium should more than cover the expected move long-term. And so, if you stay small, stay consistent with these strategies, you’re going to be on the winning end as an option seller and try to let everyone else try to expect and over-anticipate where things are going to go in the future. As always, hopefully this helps out. If you guys have any questions, let me know and until next time, happy trading.

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