did anyone play healthcare stocks prior to the Supreme Court decision?
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By StepBack
Hello Forum,
I'm new so please pardon me for not choosing the right sub. I do have data from options with different Strike prices, times to maturity & IV. I thought that a longer time to maturity ceteris paribus always results in a higher IV. However, I fount in the data that if the strike is significantly lower than the underlying, then the IV is higher for shorter times to maturity. Can someone explain to me why that is the case?
Thank you very much!
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By Pat Crawley
What is IV Crush?
I liken IV crush to a concert venue two hours after the headliner finishes their set. If it’s not closed, very few people are still in the building. In the hours leading to the concert, more and more people entered the venue at an increasing rate. There’s a decent showing for the openers, more viewers for the co-headliner, and then everyone who has a ticket is in the building by the time the headliner gets on stage.
But as soon as the show ends, the building empties out.
The same thing in option prices in the lead-up to the announcement of an earnings report or other significant catalyst. Traders pay for a ticket (an option) to watch the concert (earnings report). Once the company’s done reporting, they pack up and go home (option prices go back to normal).
Oftentimes, even if a stock misses earnings expectations and the stock declines, IV crush will still occur, which makes little sense. However, you have to understand that uncertainty about the report is one of the primary reasons that IV gets elevated prior to a report, so even a bad report that leads to a price decline still gives investors piece of mind that they know where the company stands.
Implied Volatility
Let’s just get clear on what implied volatility is. IV is the market’s estimation of future volatility determined by market prices. Essentially, using the price of an option, you can reverse engineer what the market is forecasting the expected move to be.
When implied volatility is high that means option traders are paying up for options in the expectation of a large move, like an earnings beat or miss.
A Hypothetical Trade to Demonstrate IV Crush
Imagine we’re trading Netflix (NFLX) earnings. Perhaps they just released their biggest hit show in history, by a long shot. Many analysts and traders alike are betting that Netflix will show huge subscriber growth this quarter. Many of them are buying call options to potentially profit from Netflix stock rising on the good news.
But those speculating on Netflix earnings have to buy their options from someone. On the other side of that trade is usually a market maker, who is just there to provide liquidity and try to make a one tick profit on each trade. The market makers also know about the potential for Netflix to have a blockbuster earnings report, so they start charging more for their call options.
Some skeptical hedge fund managers come out of the fray and begin buying put options on Netflix because they think subscriber growth has peaked, and the talk of a blockbuster quarter is hype from retail traders. The market makers have to start charging more for puts too. The more uncertain they are, the higher a premium they need to take on risk.
Through a less-simplified-version of this process is how the implied volatility of options gets so high prior to an earnings report. Everyone knows stocks make big moves after earnings and there’s no free lunch in financial markets so of course market prices reflect this reality.
Fast forward, Netflix releases their earnings, the numbers are good but not great. The stock hardly moves, and perhaps even slightly declines as the market expected better. That unknown variable of earnings is now known, so there’s no justification for high implied volatility now. Option prices decline and earnings speculators experience losses, often even if they were marginally correct on the trade idea.
IV Crush Example
GOOGL was expected to announce earnings on Feb.2 2023. The options market expected 7.4% move (the price of the ATM long straddle. Options IV on Feb.2 was 178%.
You can calculate a stock’s implied move by determining the price of a straddle for the closest expiration after earnings. The straddle is the market’s expectation, or implied move, for the stock. For example, if a stock is trading at $100 the day before its earnings announcement and the combined price of an at-the-money (ATM) call and put is $5, the stock’s expected move is $5 or 5%. If the stock moves less than $5 in either direction after earnings, then the actual move of the stock was less than the implied move.
With GOOGL trading around $107.60 before the close, traders could buy the 107/108 long strangle, betting that the stock will move more than the Implied Move.
Fast forward to the next day - GOOGL moved only 3%, the options IV collapsed 150% and the strangle has lost almost 70%.
Remember: nobody can predict how much the stock will move after earnings. The only certain thing is IV crush.
Profit From IV Crush
It stands to follow that if habitual buyers of earnings volatility consistently lose, then the traders on the other side of their trades should consistently win. To an extent, this is true. But it’s not enough on its own.
If we think about IV crush, it’s the market overreacting to future uncertainty about a catalyst like earnings. They’re scared of volatility and will make a -EV bet (buying an earnings at a high IV) to mitigate that edge. Or maybe they’re just speculating on earnings, which is quite popular post-2020.
These are textbooks markers to a good trade. You have a counterparty that is trading for a reason other than to maximize gains and intentionally making a fundamentally poor trade.
But there’s a caveat to all of this. Earnings (and other events that lead to IV crush) are actual volatility events. Stocks routinely make big gaps on earnings! It’s easy to forget this when you’re in the weeds figuring out how to exploit IV crush--but the IVs are high for a reason, and realized volatility is routinely near or in excess of the IVs.
So, you can profit by taking the other side of the trade (selling options instead of buying them). But this is a very risky strategy because if the stock moves more than expected, you might face significant losses. So it’s not a layup trade. Like nearly any trade, you have to pick your spots tactically.
The bottom line
A volatility crush is an opportunity for traders to take advantage of a pattern of predictable price movement across the options market. When you understand premium rates increasing during a substantial event (like earnings) followed by the decrease in implied volatility, you can make smarter trades, informed positions, and better moves for your overall account.
For any trader, implied volatility (IV) is one of the most important considerations because it has a direct impact on pricing. It’s even more important now as IV spreads have grown significantly wider, and the concept of a “volatility crush” has become an increasingly viable options trading strategy. Implied volatility increases significantly before an earnings announcement and this increase is due to option writers who want to ensure adequate protection of their portfolios from significant price fluctuations in the market.
Like this article? Visit our Options Education Center and Options Trading Blog for more.
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By Kim
However, not all stocks are suitable for that strategy. Some stocks experience consistent pattern of losses when buying premium before earnings. For those stocks we are using some alternative strategies like calendars.
In one of my previous articles I described a study done by tastytrade, claiming that buying premium before earnings does not work. Let's leave aside the fact that the study was severely flawed and skewed by buying "future ATM straddle" which simply doesn't make sense (see the article for full details). Today I want to talk about the stocks they used in the study: TSLA, LNKD, NFLX, AAPL, GOOG.
Those stocks are among the worst candidates for a straddle option strategy. In fact, they are so bad that they became our best candidates for a calendar spread strategy (which is basically the opposite of a straddle strategy). Here are our results from trading those stocks in the recent cycles:
TSLA: +28%, +31%, +37%, +26%, +26%, +23% LNKD: +30%, +5%, +40%, +33% NFLX: +10%, +20%, +30%, +16%, +30%, +32%, +18% GOOG: +33%, +33%, +50%, -7%, +26%
You read this right: 21 winners, only one small loser.
This cycle was no exception: all four trades were winners, with average gain of 25.2%.
I'm not sure if tastytrade used those stocks on purpose to reach the conclusion they wanted to reach, but the fact remains. To do a reliable study, it is not enough to take a random list of stocks and reach a conclusion that a strategy doesn't work.
At SteadyOptions we spend hundreds of hours of backtesting to find the best parameters for our trades:
Which strategy is suitable for which stocks? When is the optimal time to enter? How to manage the position? When to take profits?
The results speak for themselves. We booked 147% ROI in 2014 and 32% ROI so far in 2015. All results are based on real trades, not some kind of hypothetical or backtested random study.
Related Articles:
How We Trade Straddle Option Strategy
How We Trade Calendar Spreads
Buying Premium Prior to Earnings
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
The Less Risky Way To Trade TSLA
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By Kim
Consider selling strategies when options are being traded at high implied volatility levels.
Consider buying strategies when options are being traded at low implied volatility levels.
The following infographic explains some of the aspects of the Implied Volatility:
1. What is Implied Volatility?
2. 2 types of volatility.
3. How options are affected by Implied Volatility?
And more.
We invite you to join us and learn how we trade our options strategies.
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By Kim
Implied volatility increases when the market is bearish. On the other hand, it decreases when the market is bullish.
Implied volatility can be derived from the cost of the option. If there are no options traded on a given stock, there would be no way to calculate implied volatility. If there is an increase in implied volatility after a trade has been placed, the price of options generally increases. This is good for the option owner whereas bad for the option seller. If implied volatility decreases after the trade is placed, the price of options also decreases. This is good for the option seller and bad for the option owner.
In order to know more about implied volatility, please refer the given infographic.
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By Michael C. Thomsett
Implied volatility is an estimate based on current levels of price and moneyness, but these matters change every day.
Timing of option trades is likely to be improved by relying more on price-related and momentum signals, and not aimed at the effort to estimate future volatility. Today’s volatility tells traders what they need to know to time their decisions profitably. Consideration such as moneyness and proximity matter. When the current price per share is close to the option strike, timing is likely to be improved, whether entering or exiting. Another form of proximity is related to price in comparison to resistance or support. Most reversal signals are most reliable when they occur right at these trading range borders. If price gaps through resistance or support, and reversal signals appear, this is exceptionally strong timing for options trades.
Options traders often prefer implied volatility (IV) to time trades, but this rarely makes sense. IV has value to some extent, but it is an estimate only and is based on what you see today, not on what is likely to happen in coming days or weeks. Traditionally, traders like to enter long trades when IV is low and exit when it increases; or to enter short trades when IV is high and exit when it declines. However, analysis reveals that this is equally effective when applying the analysis to historical volatility, which is more reliable because it is factual and not an estimate.
Support for relying on IV comes largely from academia, where IV is tied directly to the efficient market. However, this also is flawed. The efficient market hypothesis (EMH) states correctly that prices efficiently take news into the price immediately. However, no distinction is made between true news and rumor, so false information has the same effect on price as true information. This efficiency also fails to identify how far a stock price should move. Anyone who has observed market reaction to earnings surprises sees a big price move, often exaggerated. In comes sessions, the price retraces to previous level.
This is not efficient.
That’s the entire point. EMH is poorly named because it implies that markets are efficient, when in fact only discounting of all information (true and false) is efficient. When options traders rely on IV and point to “efficiency” as justification, they are relying on a signal containing no true value.
Proponents of IV claim that (s) the market is efficient, and this is reflected in IV and (b) this fact allows traders to accurately predict the future.
However, the efficiency of price behavior based on information often gives off a false signal, so that IV itself reflects the inefficient interpretation of price. Traders know that short-term price behavior is inefficient and chaotic, so that IV – as a direct factor of this assumption – is not reliable for timing trades.
A related problem is the significant variance in IV based on moneyness of different strikes and time to expiration. Informed short traders know that time is an ally, and time decay is a primary source for profits. However, this is easily based on historical volatility rather than on the less reliable implied volatility. A debate about which form affects option premium is unsettled; but traders will discover that relying on historical volatility provides reliable timing information to exploit volatility.
The problems with IV are evident in the wide variances of levels based on moneyness and time to expiration. This tendency to vary is called the volatility surface, and it relies on current option premium levels as the source for future movement; in truth, those premium levels are not the source, but the result of historical volatility and moneyness. A detailed study of stock and option prices concluded that there is no consistent evidence that IV determines or affects future option value. [1]
IV is not accurate or reliable, despite common belief that it is both. Another study pointed out that IV is not a valuable indicator at all:
In theory, the implied volatility is the market’s well-informed prediction of future volatility. In practice, however, the arbitrage trading that is supposed to force option prices into conformance with the market’s volatility expectations may be very hard to execute. It will also be less profitable and entail more risk than simple market making that maximizes order flow and earns profits from the bid-ask spread. [2]
Although there are five factors going into the Black Scholes pricing model (BSM), only volatility is unknown and must be estimated; and this is where inaccuracy comes into play, making the pricing model deeply flawed.
The intent of IV is to identify current volatility and predict future volatility, but it cannot predict the future. Volatility itself (defined as “risk”) cannot be quantified for the future in any case, so any assumption by traders that IV is a reliable test of future price movement, is simply untrue. This is easily demonstrated by another factor: Volatility reveals the likely movement of an option’s premium, but not the direction. Options traders are naturally interested in figuring out where the price will move, but volatility articulates the range of price movement and not the direction.
A final flaw is that as expiration approaches, volatility will become as uncertain as price of the underlying. This “volatility collapse” makes IV unreliable in the final week before expiration. But this is the week where many traders focus. If a trader is active in the final week of the option’s term, but also relies on IV, there is no certainty whatsoever of profitable outcome. A simple observation of moneyness and proximity to resistance or support makes more sense.
The use of IV can be compared to reliance on forward P/E. This is an estimate of future P/E but contains assumptions, often based on wishful thinking or flawed assumptions. It may also be compared to the accounting reliance on pro forma financial statements, estimates of future revenue, costs and net profit. This may be based on detailed forecasting that sounds scientific but, in fact, cannot be called accurate. If traders know that estimates of future P/E or net profits are unreliable, why depend on IV to estimate future volatility of options?
[1] Bouchard, Jean-Philippe & Marc Potters (2009). Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management (2nd ed.). Cambridge UK: Cambridge University Press. p. 252
[2] Figlewski, Stephen. (2004). Forecasting Volatility, New York University Stern School of Business, Preface
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
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By Nathan Wade
As public fear escalates, demand for protection against downward shifts in the stock market increases with it. This boosts the premiums for options that can be used to hedge against downward shifts in stock prices.
While some investors invest in either stocks or options, many investors use options to hedge their stock portfolios. They look for overvalued options, so that they may sell options when the premiums of those options are expensive. The best way to determine if an option premium is overvalued is to analyze implied volatility.
What is Implied Volatility?
Let’s say you have a call option. When you hold a call option, you have the right (but not the obligation) to buy a security at a specific strike price on or before its expiration date. The value of this option is determined by the probability that the call option will be in the money by the time it reaches its expiration date.
To determine the likelihood that an option will be in the money before the expiration date, you need to figure out how quickly it will move in the right direction. But how do you do that?
Option traders, like Warren Buffett, turn to implied volatility. Implied volatility is a measure of how much market participants believe the price of a security will move over a specific period on an annualized basis. It’s typically represented as a percentage.
An implied volatility of 20% means that traders estimate a security will move up or down 20% from its current position over the next 12 months. To determine the premium, or price, of an option, you could use an option pricing model. The most famous is the Black Scholes option pricing model. There are several inputs, but the most crucial is implied volatility.
How Do You Measure Implied Volatility?
There are a few ways to measure implied volatility—but the easiest way is to evaluate an available index of implied volatility.
You can chart implied volatility on several instruments including the VIX volatility index. Additionally, you can use technical analysis tools such as Bollinger bands and the RSI to help you decide of the value of implied volatility is rich or cheap.
The VIX volatility index, which is calculated by the Chicago Board of Options Exchange (CBOE), lists the implied volatility of the “at the money” calls and puts on the S&P 500 index. The VIX reports how far traders believe the S&P 500 will move over the course of the next year.
The CBOE produces many different VIX indexes. There is a VIX on Apple shares and a VIX on crude oil. By charting the VIX, you’ll be able to determine whether implied volatility is rich or cheap.
How Do You Know When Implied Volatility is Rich?
When implied volatility is high, or “rich,” option prices are overvalued. This attract investors like Buffett. This is when you want to sell options.
You can determine how rich volatility is by using technical analysis tools like Bollinger bands or the Relative Strength index. When the value of the VIX moves up to unsustainable levels, you’ve reached a trigger point. This is where you should look to sell options.
Bollinger bands are a technical analysis tool that measure a 2-standard deviation range around a moving average.
The chart of the VIX shows that the VIX shot above the Bollinger band high in early October, which was calculated using a 200-day moving average. This also happened in March and February of 2018. When the VIX crosses above the Bollinger band’s high, it’s likely to revert back to the mean. But before it returns, you can attempt to sell an option. You can use several different moving averages to determine if the value of the VIX volatility index is high. It all depends on your time horizon.
A second technical analysis gauge you can use to determine if implied volatility is rich is the relative strength index (RSI). This is a momentum oscillator that measures accelerating and decelerating momentum along with overbought and oversold levels. When the RSI moves above 70, the value of the security is overbought and will likely correct itself. In early October the VIX hit an RSI reading of 84, well above the overbought trigger level of 70—meaning the volatility was rich.
There are other tools that you can use to measure implied volatility. There are vendors that provide historical charts of implied volatility on individual stocks. You can use the same type of technical analysis tools to determine whether the implied volatility on these shares are rich or cheap.
When Should I Check Implied Volatility?
You can use implied volatility as a confirmation indicator or a trigger. The process goes as follows:
Once you find a stock that you believe is undervalued, you might consider selling a naked put below the current stock price.
You would then check the stock to see if current implied volatility is elevated and use that to determine whether or not selling an option on that stock is worthwhile. Alternatively, you can use implied volatility as a trigger. In this case, you could scan for implied volatility levels on stock prices where the Bollinger band’s high has been breached or the RSI is above the 70 overbought trigger level.
You can then find a level that would make selling a naked put or a covered call attractive.
A Final Message
The best options strategies are income producing option trading strategies. These include popular trading strategies, such as covered call and naked put trading. It does not matter if you are selling a naked put or employing a covered call strategy, you want to sell options when premiums are overvalued.
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By jhollett
Where is the best place to find a list of low IV stocks such as NKE that will have really strong Gamma gains on moves. I've had success trading straddles on NKE before joining the group and is it a matter of looking through a bunch of stuff or is there a site that will help aid in that search?
Thanks
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By Kim
The problem is you are not the only one knowing that earnings are coming. Everyone knows that some stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.
Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In many cases, this drop erases most of the gains, even if the stock had a substantial move. In order to profit from the trade when you hold through earnings, you need the stock not only to move, but to move more than the options "predicted". If they don't, the IV collapse will cause significant losses.
However, there are always exceptions. Stocks like NFLX, AMZN, GOOG tend on average to move more than the options imply before earnings. It doesn't happen every cycle. Few cycles ago NFLX options implied 13% move while the stock moved "only" 8%. A straddle held through earnings would lose 32%. A strangle would lose even more. But on average, NFLX options move more than expected most of the time, unlike most other stocks.
NFLX reported earnings on Monday October 17. The options prices as indicated by a weekly straddle "predicted" ~$10 (or 10%) move. The $100 calls were trading at $5 and the puts are trading at $5. This tells us that the market makers are expecting a 10% range in the stock post earnings. In reality, the stock moved $19. Whoever bought the straddle could book a solid 90% gain.
Implied Volatility collapsed from 130% to 36%. Many options "gurus" advocate selling options on high flying stocks like NFLX or AMZN, based "high IV percentile" and predicted volatility collapse. However, looking at history of NFLX post-earnings moves, this doesn't seem like a smart move.
As you can see from the table (courtesy of optionslam.com), NFLX moved more than expected in 7 out of 10 last cycles. For this particular stock, options sellers definitely don't have an edge, despite volatility collapse. If the stock moves more than "expected", volatility collapse is not enough to make options sellers profitable.
Generally speaking, I'm not against selling options before earnings - on the contrary. For many stocks, options consistently overestimate the expected move, and for those stocks, this strategy might have an edge (assuming proper position sizing). But NFLX is one of the worst stocks to use for this strategy, considering its earnings history.
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Why We Sell Our Straddles Before Earnings Why We Sell Our Calendars Before Earnings How NOT To Trade NFLX Earnings The Less Risky Way To Trade TSLA
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