Huge Swings in Volatility

In this article, I will address one of the questions that Ihave recently been asked. It is on the topic of huge swings in the impliedvolatility on an individual stock. In order to get to the bottom of the issueunder discussion, I have utilized the CBOE’s Option Calculator. Here is thequestion that I was asked:

I own a biotech stock that is currently trading around $50and I have recently sold some 55 strike covered calls with the expiration nextmonth. The very next day, out of nowhere, positive news came out and the stockjumped $3. However, the value of the option fell by nearly 30%. How can thatbe?

The simple answer to your question is that the impliedvolatility decreased, which in turn has caused the premium of your 55 call todecrease as well. I am glad that the price did not rally above your sold 55call, which could still happen. There is a possibility that within the nextmonth or so, your stock could lift an additional two points which would thenmake your sold 55 OTM (out-of-the-money) calls in-the-money (ITM). In thatcase, you need to make a choice whether you still want to keep the stock, orlet it get called away from you. The choice is entirely yours.

Now let me address the issue of “How can that be?”in greater detail. At Online Trading Academy, we discourage tradingpharmaceutical stocks just because of the high volatility shift that can takeplace for various reasons. For instance, prior to a major announcement, theimplied volatility of these stocks (Pharmaceutical or Biotech) could get up toextreme levels. Yet, after the announcement, volatility usually comes back tothe stock’s normal trading range. It’s quite common for novice traders tounderestimate the impact of a change in volatility.

Taking into account that the value of the option premiumfell by 30%, I would assume that the implied volatility was 80% before theannouncement and 50% afterwards. To ensure that this assumption is NOT withoutquantification, let me run some calculations using the options calculator fromthe CBOE website.

What I have done in the figure above is basically enteredthe info that I was given. Line by line the entered info is the following: Forthe Style (of options), I have kept it on the default setting meaning American,for the Price I have entered $50, and for the Strike $55. The ExpirationDate/Days to Expiry, I entered 30 days, for that is what the person asking thequestion had said. Volatility is something that I have entered on my ownchoosing, while the Interest Rate% was defaulted to 0.2578 due to Mr. Ben B. Ihave left blank the places for dividends. Once this info was entered, I clickedon Calculate and Figure 2 shows what the premium and the Greeks came out forthe 55 call.

To recap the info from above, the 55 call premium of the OTMoption with 30 days to expiry and the IV of 80% should be priced $2.70 with adelta of .38 cents. (For simplicity’s sake, I will not go through the rest ofthe Greeks.) After knowing these facts, let us change the variable in theoption calculator by changing the data in the following way. First, the Priceshould be changed to $53, Days to Expiry decreased by one, and IV dropped by30%. Figure 3 shows those changes.

Again, after pressing CALCULATE, the new results for the 55call were: Option Value or premium of the 55 call at $2.14 with a delta of0.42.

Now, take a moment and just think about the impact ofchanges in volatility on trading options. Had the IV remained at the same level(80%) and the stock had rallied 3 points, this is how the incremental increaseof the delta for that 55 call would look like.

At $50 the 55 call is still worth $2.70 yet when the stocklifts to $53, within a day, the 55 call should be worth almost four dollars, ($3.9493to be exact). However, none of that happened because the IV dropped 30%reducing the premium of the 55 call, which originally was $2.70 with theunderlying sitting at $50, to a mere $2.14, while the underlying is at $53.

In conclusion, the decline from $2.70 to $2.14 took placeeven though the stock price increased three whole points from $50 to $53. Theimpact of the change in implied volatility easily outweighed the price changeof the stock. In short, it is crucial to understand the impact that changes involatility have on options.

Know your Greeks and have Green Trading.

Josip Causic can be contacted at The Online Trading Academy

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