Option trading basics teaches us that selling call and put options is actually selling time value. Time value consists mainly of time to expiration stats and the implied volatility (IV) of the underlying security. Since most of us are selling monthly options, the main distinguishing factor in our option prices is the implied volatility…we are selling volatility.
In this article we will take a look at how implied volatility is impacted by individual stock events and then we will take a broader look as to how implied volatility is influenced by supply and demand for options based on market perception.
There are certain events that can cause the market to anticipate a significant price change in our stocks and exchange-traded funds (ETFs) and therefore elevate the implied volatility of the associated options. The most common of these circumstances are earnings reports, a topic I will never stop discussing because I consider it so important to our ultimate success. Other events, like impending FDA announcements of drug approvals and Federal Reserve announcements (among others) will also elevate implied volatility and therefore our option prices. However, higher IV also means greater risk as share value can decline significantly thereby resulting in substantial losses. This is why a BCI golden rule is to never sell a covered call or put option when there is an upcoming earnings report prior to expiration Friday. Although IV is influenced by a myriad of factors, earnings reports are one of the most common and important as shown in the chart below highlighting the volume spikes (as shown by the CBOE Volatility Index or VIX) in each of the last 4 earnings quarters:
General market perception
Options are used for three major reasons:
- Generating cash flow (that’s us!)
- Speculation (betting a stock price will move up or down)
- As a risk management tool (hedging)
Institutional investors (mutual funds, hedge funds, banks and insurance companies) use options to protect their multi-million dollar portfolios. When there is an impression that risk is increasing, there is a greater demand for option hedging (buying puts as an example) and as a result prices of these securities will rise. On the other end of the spectrum, when the market is presuming a period of lower volatility the demand for option protection is lessened and therefore options are sold and prices decline.
There is a greater demand for call options as IV increases because shares of stock can be controlled at a much lower cost and if the trade turns against them, there is less capital risk than if the shares had been purchased. In addition to this, during times of low volatility, speculators will turn to selling options (just like us) to elevate the returns they are not receiving due to the low-implied volatility environment.
Long option positions are supported by high volatility conditions while short option positions benefit from low volatility situations. Buying and selling options is equivalent to buying and selling volatility.
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Friday, November 21st
This week’s data was mixed but still re-enforcing the continued expansion of our economy:
- The unemployment rate for October dropped for the 3rd consecutive month to 5.8%
- According to the Labor Department 214,000 non-farm payroll jobs were added but below the 231,000 projected
- The ISM Manufacturing Index rose to 59.0 in October above the 56.8 expected
- The ISM Non-Manufacturing Index declined slightly to 57.1 in October but still reflecting expansion
- Hourly wage growth increased by its 6-month average of 2%
- Non-farm business productivity increased by an annualized 2.0% for the 3rd quarter, above the 1.5% rate anticipated
- Construction spending in September fell by 0.4%, below analyst’s expectations
- Factory orders in September dropped by 0.6%, also below expectations
- Initial jobless claims for the week ending November 1st came in at 278,000, slightly below the 285,000 projected
- The US trade deficit widened to $43 billion due to the stronger US dollar and a weakening global economy
- Manufacturing productivity increased by 3.2% for the 3rd quarter above the 2.5% expected
For the week, the S&P 500 rose by 0.7%, for a year-to-date return of 12%, including dividends.
IBD: Confirmed uptrend
GMI:6/6- Buy signal since market close of October 27, 2014
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Wishing you the best in investing,
Alan ([email protected])