77%10-day historical volatility: 36%20-day historical volatility: 42%50-day historical volatility: 46%100-day historical volatility: 49%
Option
Price
Volume
Implied Volatility (%)
Oct 71⁄2 callDec 71⁄2 callMar 71⁄2 callOct 10 callNov 10 callDec 10 callMar 10 call
0.811.311.810.190.380.501.00
700200200500200200200
76767885817576
Total volume was a healthy 2,200 contracts; but because the averagevolume was an inflated 2,444 contracts, this stock doesn’t show up on thevolume screens. However, the daily implied volatility is 78 percent, well
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above the 20-day moving average, and well above the historicals also. Sincethe individual options also look speculative in nature, we would want to takea look at IDC as a trading candidate. It quickly moved two points higher.
Thus, implied volatility was useful in even a situation where wehad relatively active options because it helped identify a potentialtrading candidate even though the volume screens would not.As a final word on using implied volatility to select speculativestock trading candidates, let me stress that volume is still important.Without volume eventually appearing, I wouldn’t get too excitedabout buying the stock. Thus, in the previous examples, the impliedvolatility is used to identify a potential trading situation; but I wouldusually want some confirmation from volume (which may not comefor a few days) before taking too large a position in the stock. Thereason that we want a volume confirmation is to avoid being in astock that suffers a huge gap to the downside; for option impliedvolatility can be a predictor of such gaps also, as we see in the nextsection.
Implied Volatility Can PredictTrading GapsWhen a corporate event that is going to cause a large change in astock’s valuation is on the horizon—and it may be a publiclyannounced event—the options will become extremely expensive inadvance of the actual event occurring. One example could be theappearance of a small biotech company before the Food and DrugAdministration (FDA) regarding approval of the company’s onlyviable drug. Another might possibly be the pending culmination of alawsuit whose outcome will cause a company’s (or perhaps even twocompanies’) stock to change in price dramatically.What we are basically talking about here is an event that will dramatically change the fundamentals of a corporation. After theannouncement of the event, the company’s fortunes will havechanged so much that its stock price will be drastically different.These types of events can also be forewarned of by implied volatility
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increases in a stock’s options. What cannot be foretold in these situations, however, is the direction in which the stock will move, onlythat the stock will move.This can still be useful information, especially if you are already astockholder or if you are considering making a purchase of the stock.If the options are foretelling a major price change in the stock—direction unknown—you may want to avoid the stock until the newsevent is released.In these situations, we are not talking about a news event that is“leaked” in advance. In general, no one knows what these outcomeswill be. Courts do not release their verdicts in advance to anyone (infact, if it is a jury trial, no one even knows what the verdict will beuntil it is announced in court). Nor does the FDA leak any of its decisions in advance.A few actual historical examples will best serve to illustrate thisphenomenon. We have already alluded to a couple of these in previous chapters. One was the Intel Corporation patent-infringementlawsuit against Advanced Micro Devices (AMD).As the date approached, in March 1994, for the court to reach a decision,the implied volatility of options in both stocks increased; but those ofAdvanced Micro, the smaller company, were most noticeable. Intel’s normaldaily implied volatility was about 30 percent; but just before the announcement of the verdict, it grew to nearly 40 percent—an increase, but notmuch of one, as you shall see from these examples. On the other hand,Advanced Micro’s normal daily implied volatility was in the 50 to 60 percent range. But, during February and early March 1994, its implied volatility rose first to 120 percent and then to over 130 percent! Now that’s anincrease in implied volatility.All of this increase in volatility was taking place without the stocks actually changing much in price, because no one knew which way the verdictwas going to go. However, they did know that the stocks would reactstrongly when the verdict was eventually announced.When the verdict was finally announced, Advanced Micro had won.The stock jumped six points higher. AMD’s implied volatility immediatelycollapsed, dropping down to 58 percent after the verdict. Intel fell threepoints over a two-day period following the verdict.
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Some trial outcomes are less difficult to predict. Obviously, theAMD/ Intel trial was a “too close to call” situation. Large tradingfirms employ their own lawyers to give them guidance on how a trialmight turn out, and they sometimes even send lawyers to the courtroom to observe the proceedings. If they can glean an indication ofwhat the trial’s outcome might be, they can act before most otherinvestors. In general, though, there is little or no clue as to the outcome. As I wrote in my daily fax report, prior to a court verdict beingreleased, “attempting to predict these outcomes is about as difficultas predicting an election (look in your encyclopedia under ClementAttlee, Harry Truman, or George Pataki if you think elections arepredictable), which is why the premiums are so high.”Another patent suit is also a good example. It involved Interdigital Communications (IDC) and Motorola (MOT); we referred to it inthe IDC example at the end of the last section.As mentioned in that previous example, IDC rallied from 3 to 13 on theback of a plethora of new contracts being signed. Also, apparently, thestock was rallying partly on some investors’ expectations that it would winits patent lawsuit with Motorola.Since IDC was a low-priced stock to begin with, its normal daily impliedvolatilities were very high, in the 100 percent to 110 percent range. However, as the verdict drew near, in March 1995, implied volatility in IDCbegan to skyrocket. It routinely registered levels of 150 percent to 170 percent at that time.The stock was trading at 12 when the court decided in favor ofMotorola. IDC opened down seven points the next day. Implied volatilityfollowed its normal pattern then, by dropping to 85 percent. Once the newsis out, implied volatility returns to a much lower level.
This IDC example is a good illustration of how the increase inimplied volatility might have been a good warning sign for aninvestor. If you had bought IDC at a lower price, you were enjoyingthe ride from 3 to 13. During that time, the company was announcing the signing of new contracts with a great deal of frequency. If youwere only interested in the fundamentals of the stock (or the technicals, for that matter), everything appeared to be quite rosy. However,if you noticed the option premium exploding, you were given
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advance notice that the stock was in a high-risk mode. It might gapeither up or down, but something was going to happen. Thus, if youdidn’t want to risk your accumulated profits, you could have sold,exiting in advance of the court’s decision.Hearings by regulatory bodies can be as important to the futureof some stocks as the outcomes of lawsuits are to others. This isespecially true of small biotech or drug companies, because not onlyare FDA decisions not leaked in advance, but they are often so arbitrary that no one can predict the outcome. Thus, the options of asmall biotech or drug company will often expand to very expensivelevels as the date nears for the FDA to release its findings. Readersare referred to the example of Gensia Pharmaceuticals in Chapter 1.The graph of Gensia and the implied volatility of the options areshown in Figure 4.15. Even though the stock was up 1 to 10 points
Figure 4.15GENSIA PHARMACEUTICALS
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on the day before the FDA announcement, it received an unfavorable ruling and dropped 50 percent, to 5 points. Thus, it was evidentthat stock traders—at least those who pushed the stock up a pointthe day before—had no real clue as to the direction that the stockwould take after the ruling. Neither did option traders, but at least theoption premium was telling you as much. The following example isrelevant as well.United Bioscience (UBS) was a fledgling biotech company, trading at about$7 a share in late 1994 (the stock had been nearly twice that price about ayear before, but delays in getting its drug approved by the FDA had weighedupon the stock price). On a normal day, the implied volatility of UBSoptions was in the 50 percent to 60 percent range.In November, when traders learned that the FDA hearing was scheduled for early December and that it could potentially decide the fate of thecompany, option implied volatility rose to 135 percent. By early December,it had reached an astounding 185 percent.On December 12, the FDA declined approval for the drug, and the stockdropped to 21⁄2. Essentially, the option’s implied volatility dropped to 0because the nearest strike price was 5, which was 100 percent above thestock price. In fact, the options were delisted when the stock didn’t recover forseveral months. If the stock ever recovers, options will probably be relisted.
There can be other miscellaneous events that have similar effectson stock options. One that comes to mind occurred in 1995, and itinvolved Genetech and Roche, the large European drug companythat owned warrants to buy all of Genetech. As those warrantsneared their expiration date, the implied volatility of Genetechoptions doubled because if Roche did exercise their warrants,Genetech was going to jump higher in price. However, if Rochedecided not to pursue Genetech, the stock could have fallen a greatdeal. As it turned out, a middle ground was reached when Genetechallowed Roche to extend the expiration date of the warrants for fouryears, in return for raising the exercise price. In any case, holders ofGenetech were alerted to the potential explosiveness of the warrantexpiration (something the average stockholder may not have beenaware of ) by the increasing volatility in the options.
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Sometimes, the consequences are less severe but may be veryimportant just the same. In the early fall of 1995, IBM had brokenabove 100 for the first time in years and was merrily trading up to115 when it suddenly changed direction and began a fairly steadyand rather quick decline to 103. Option implied volatility jumpeddramatically (for IBM, that is) from about 30 percent to 40 percent.This was a warning sign that something more severe than a technicalcorrection was happening. A few days later, the company indicatedto analysts that sales figures (and, by inference, earnings) should beadjusted lower. The stock quickly dropped to 92 before stabilizing.The volatility and price swings in this example are smaller, but itshows that a sudden increase in implied volatility should be heeded asa possible precursor of important corporate news.Thus, a sudden increase in implied volatility without an accompanying move by the underlying stock can be a warning sign that aprice gap is about to occur. It behooves us to pay attention to thepremium level of the options before entering a stock position andeven after buying the stock. Whether or not you are an option trader,the options may give you fair warning of a catastrophic event on thehorizon. As a stock owner, you may not notice anything unusualfrom watching the stock trade; but if the options are too excited,then you’d better do a little extra research to find out why.
Some Strategies for Trading theVolatility GapIn this section, we look at two strategies for trading the volatility gapsdescribed in the previous pages. The first is what we call the eventdriven straddle buy. The second is merely an attempt to trade thevolatility as it is increasing.The event-driven straddle buy is best used when the date of theevent is known. For example, if a company is having an importanthearing before the FDA, the date is known. In fact, these FDA hearings are usually quite volatile, particularly if the FDA denies the company’s application, which usually causes a very large price drop—often larger than the option market was expecting. A favorable ruling
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from the FDA usually causes the stock to move higher, but generallynot all at once—it may several weeks. In either case, it can behoovean aggressive trader to buy a straddle on the stock right before theevent.Liposome Technology (LIPO) was trading near a price of 21 in late July1999 when the company announced that an important FDA hearing wouldbe held on September 16. Implied volatility immediately began toincrease—rising from about 70 percent at the time of the initial announcement to about 160 percent on the day before the FDA hearing. Refer toFigure 4.16 for a graph of this information. On the graph, point A is theday of the first announcement, and point B is the day before the hearing.As you can see, the stock rallied briefly at first; it then went into adecline and closed at almost exactly 171⁄ 2 on the day before the FDA hearing. Since the FDA does not leak its decisions in advance, there is no way
Figure 4.16LIPOSOME TECHNOLOGY
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that stock traders can know for sure what the FDA will decide. So, on theday before the hearing—September 15, in this case—we buy a near-termstraddle. In this case, the Sept 17.5 straddle, due to expire in just threedays, cost 4.75. FDA hearings only last for one day, so there was no chancethat we’d get stuck in this straddle while the FDA dawdled. In fact, on September 17, the decision was already out, and the answer was “no.” Thestock immediately dropped about 10 points, so the straddle buy was nicelyprofitable.
Similar FDA hearings for relatively small biotech companies haveproduced massive moves over the years. This is a strategy that canbe employed perhaps five or six times a year, although, as stated earlier, a positive result from the FDA panel will probably produce a lossfor the straddle owner—at least initially.We mentioned that a second strategy was possible. In lookingat the graph in Figure 4.16, you might be thinking, “Why not just buythe straddle when the company first announces that it’s going to be thesubject of an FDA hearing?” That, too, is an acceptable strategy.Then you are owning the straddle while implied volatility increases(between points A and B on the graph). If you choose to employ thisstrategy, however, you must be certain to sell the straddle before theFDA makes its announcements. Otherwise, the stock could revertright back to your striking price and cause you to lose. For example,in the LIPO example, if you had originally bought the Sept 25 straddle when the stock was near point A, it would have worked well asthe stock fell to 171⁄ 2. However, you must sell it then, because thereis a chance that the FDA could approve the product and the stockmight trade right back up to 25—a disaster for your straddle holding.In general, no matter which strategy you are employing, youshould realize that the stock might halt for trading on the day of theFDA hearing itself. So establish your event-driven straddle buy; or ifyou bought straddles early on, sell them out on the day before theFDA hearing. You don’t want to get caught by the trading halt.Sometimes, it is difficult to find out why a stock’s options areincreasing in volatility. Even FDA hearing dates are sometimes buriedin news minutia and are hard to find. If you are using the initial strategy, that is not a problem. In fact, studies that we have conductedhave shown that if a stock’s options are suddenly volatile for at least
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four consecutive days, then there is a very large chance that a volatileevent lies on the horizon. So, you can buy straddles then, intendingto benefit from the increase in volatility until an event is clearlyannounced or until one occurs.Trading volatility in this manner is quite speculative because youare buying expensive, short-term options. However, the movementin the underlying stock is often even larger than the option marketwas expecting, allowing you room to profit. I would not use this strategy with index or futures options— only stock options, for stocks arefar more chaotic than indices or futures.
IMPLIED VOLATILITY CANPREDICT A CHANGE OF TRENDIn the previous section, implied volatility was increasing while theunderlying stock was fairly docile. In this section, we’re going to seehow the observance of extreme volatility levels—both high and low—might be useful in predicting the end of a trend in the price of theunderlying security. In certain cases, this applies not only to stockoptions, but also to index and futures options.In general, for both stocks and indices, a declining (bearish) market means increasing volatility, while a bullish market has decreasingvolatility. This statement refers to both historical and implied volatility. Sometimes it helps to think in extremes to help visualize generalstatements like this (mathematicians call this “evaluating the boundary conditions”). In this case, the most extreme bearish case I canthink of is the crash of 1987. Volatilities shot through the roof atthat time. Other similar events that demonstrated this increasingvolatility in down markets were the “crash” of 1989 (the day theUnited Arab League deal fell apart), the collapse of 1990 (when Iraqinvaded Kuwait), the severe double declines in September and October 1998 (Russian debt crisis and the Long-Term Capital HedgeFund crisis), and the final leg of the market in 2002. As for upsideextremes, the bull market of 2003 is a good example: volatilitiessteadily decreased for the broad market indices as the market continued to push higher.
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There are several factors at work in producing these volatilitychanges. One is that stocks tend to fall faster than they rise. Bullmarkets take years; bear markets may take only months. The2000–2002 bear market lasted nearly three years, but that is one ofthe longest ones in memory. Even large ones like 1969 –1970 and1973–1974 only consumed a little over a year's time. Also contributing to these volatility differences is the fact that a low-priced stockcan move by a larger percentage more easily than a high-pricedstock can. For example, it’s not unusual to see a $5 stock move by ahalf point in a day; it doesn’t take that much buying or selling pressure to move any stock by a half point. However, that’s a 10 percentmove; and you rarely see a $100 stock move by 10 percent (10points), or even by 5 percent for that matter. Thus, we would expectto see volatility increase as prices fall and likewise decrease as pricesrise. Finally, since the indices are composed of stocks, they should,and do, display the same characteristics.Futures, however, are different; and as a result it is difficult tomake such a general statement regarding futures prices and volatility.Some futures and futures options behave like stocks do, but manybehave in the opposite manner: volatility shrinks as prices fall andmay explode if prices rise. Again, it may help to think of how commodity prices move in order to explain this phenomenon. There isan inherent demand for most commodities; and, therefore, pricescannot fall too low (in fact, some commodities, like corn, even havea government price floor under them). However, given the vagariesof droughts and floods and other similar events, commodity pricescan, and often do, explode to the upside. Thus, even though commodity markets can move with equal rapidity in both directions, theyoften move faster to the upside than to the downside.In reality, futures option volatilities will more often reflect thetrend and how fast it is moving. Grain futures tend to fall relativelyslowly, while they may rise dramatically (and many grain traders stillremember the huge bull markets of 1973 and 1974; so every timeprices start up, there is hope of a repeat of those bullish moves). Asa result, you will find that implied volatility in grain options increasestremendously during bull moves and decreases during bearish moves.However, another commodity will most likely react differently. Forexample, oil has had the potential for both big increases and big
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decreases over the years. So whenever a trend seems to be accelerating in oil prices, the implied volatility of oil options will increase.Given this general background, let’s examine how these observations can be used to establish positions that might be profitable.
Covered Call Writing WhenVolatility IncreasesWe discussed the covered call writing strategy in Chapter 2. The conclusion was that it is best used when prices are stable or rising moderately; it is not such a great strategy in volatile markets. So whatwould make a covered write a great strategy would be not only stablestock prices but also expensive options that can be sold against thatrelatively stable stock.We have just stated that implied volatility increases when stockprices fall. So if we could “catch” a stock right as its downtrend isending, we would probably find that the options are about as expensive as they are going to get; and while the stock may not reverseinto a bullish trend immediately, it will at least be stabilizing as itbuilds a bottom. If we can find this situation, the covered writingstrategy would be most appropriate.Finally, a bit of contrarian theory can be thrown into this mix aswell. If a stock has been falling for some time—perhaps rapidly—eventually put buyers will panic and start paying up to ridiculous levels for those puts. This causes the implied volatility of the options toinflate. Of course, contrarians would recognize everyone’s desire toown puts as a sign of a bottom in the stock (if everyone wants to ownputs, it must be the wrong thing to do, since the majority is usuallywrong; therefore, the stock is nearing a buy zone or at least will stopgoing down, and the large number of put buyers will lose money).All of these thoughts can be summed up in this one statement:when implied volatility reaches an extreme peak during a stock’sdowntrend, then the stock is ready to at least stabilize and possiblyto even move higher. The same thought applies to index options.A classic example of this occurred in early 1993, involving IBM. IBM’s stockhad peaked near 180 in 1987 and, after the crash, had never responded as
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well as the overall market. It was able to rally back to about 140 in thebeginning of the 1991 bull market, but then it began to stumble badly whenit was apparent that the company wasn’t positioned for the computer boomof the time. It fell slowly but steadily at first, eventually breaking 100 on thedownside in early 1992. A short rally brought it back up to 100 in June1992, and then the decline began to accelerate with a vengeance. Figure4.17, which shows both the price of IBM and the implied volatility of itsoptions, encompasses the period from August 1992 to October 1994. Thesharp decline in price during the last half of 1992 is evident on the left sideof the chart. (We mentioned this same time period back in Chapter 2 whenwe were using IBM as an example of naked put writing.)During the slow but steady part of the decline (March 1991 to July1992), IBM’s implied volatility had risen only modestly from the 20 percentarea to about 25 percent. And, in fact, when the stock rallied back to 100in June 1992, implied volatility quickly settled back to the 20 percent range
Figure 4.17IBM, 8/92–10/94
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once again. However, when the more rapid decline of late 1992 began tounfold, implied volatility began to skyrocket. You can see from Figure 4.17that it was increasing from August 1992 through November 1992, andthen it literally exploded during December 1992 (point A on the chart).Implied volatility had risen to nearly 50 percent by that time! This occurredwith the stock near 50.By early January, implied volatility was still high—near 40 percent—butit looked as if the peak volatilities had been seen. This then was a signal thatthe stock was going to stop going down. It was also a signal to begin establishing covered writes in IBM. These covered writes were very profitable,whether the strategy was followed for only a couple of months or if it took amore intermediate-term view. Look at Figure 4.17 again. You can see thatIBM stabilized and stayed near 50 through June 1993. Thus a covered writeof any (expensive) call with a striking price of 50 would have worked outvery well.If you had taken a longer-term view, things might have worked out evenbetter. You can see from the chart that even though IBM made a slightlylower low in the summer of 1993, it generally moved sideways for theentire year of 1993 and even into early 1994. However, option impliedvolatility remained relatively high during that time. Notice from the chartthat the implied volatility during all of 1993 was higher than the impliedvolatility on the far left side of the chart (August 1992). Thus, you couldhave repeatedly written covered calls and taken in expensive premiumswhile the stock price was more or less unchanged. Eventually, IBM didbegin to rally, and you would have been called away for a final time, but notbefore registering some very nice profits along the way. By late 1994,implied volatilities had dropped back into the low 20 percent neighborhood.The additional advantage that the covered writer had during 1993, ofcourse, was that he was selling options that were expensive and was therefore getting more downside protection than he was theoretically entitled to.This is when the covered write strategy is at its best.
Another similar example is found in the trading of Telefonos deMexico (TMX), or Telmex, as it is commonly called.When the peso was unexpectedly devalued in late 1994, Mexican financialinvestments collapsed in value. Since Telmex is the largest stock in Mexico(it’s the telephone company), it was a focus of attention.The chart of Telmex is shown as Figure 4.18 and includes the impliedvolatility of its options. Prior to what is shown on the chart, Telmex had
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Figure 4.18TELEFONOS DE MEXICO (TELMEX)
peaked in price at around 75, fallen into the 50s, and then rallied back intothe high 60s (point A on the chart). As had been the case with the initialdecline in IBM, the implied volatility of Telmex options did not really changemuch; it was near 30 percent the entire time.In fact, except for a small spike in volatility in late August 1994, theimplied volatility stayed pretty stable even while the stock was falling. InNovember and December, the stock was falling to a price of 50, andimplied volatility was increasing very gradually. Then the peso devaluationcame, and the stock began to fall rapidly. Implied volatility jumped, too, andreached an interim peak in January 1995 at over 70 percent (point B onthe chart). The stock was trading in the 33-to-35 area by that time.In February, it appeared that implied volatility had peaked (point C onthe chart), and covered writes might have been established at that time. Asit turned out, that was premature, as prices dropped to near 25 and implied
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volatility shot back up again in March (point D on the chart). By late March,it again appeared that implied volatility had peaked, so covered writes wereagain warranted. The stock was at or just below 30 then. So, whether youhad established the covered writes in February with the stock near 35 or inMarch with the stock near 30, you still had a good position. As you can seefrom the chart, the stock stabilized for months, trading sideways through thewhole summer of 1995. Eventually, implied volatilities dropped back downinto the 35 percent range, and the scenario was finished.
The Telmex example again demonstrates the viability of lookingfor situations where implied volatility is skyrocketing while the stockis falling. Once the volatility peaks, covered writes are a preferredstrategy. The example also demonstrates a problem with the strategy, in that volatility may appear to have peaked, only to increaseonce again. This problem can be at least partially countered by taking only a half position on the first decline in volatility, with plans toadd to the position as time passes.One might think that given the apparent success of looking forhigh implied volatility, there might be a corresponding strategy associated with low implied volatility. If there is, it is much less evident forstock options (we’ll see shortly that it’s better used with index options).Obviously, if you feel that implied volatility is too low and, therefore,that the options are too cheap, you can consider option-buying strategies. These would primarily be straddle purchases; but stock optionscan get cheap and stay cheap for a long time, causing woe for straddleowners. So, watching for exceedingly low implied volatility in stockoptions may sometimes be worthwhile, but it is a strategy that has tobe used selectively. It is discussed extensively in Chapter 6.
Implied Volatility of Index OptionsThe same philosophies regarding the use of implied volatility as apredictive tool for stocks can be applied to index options— often withmore accurate results than using them on stocks. This is especiallytrue of the broad-based indices, such as the Standard & Poor’s (S&P)100 Index (OEX) or the S&P 500 Index (SPX). When the market iscollapsing and implied volatility is exploding, the market is nearing a
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bottom. When implied volatility finally peaks and begins to fall, thatbottom has often been reached. Conversely, if implied volatility getstoo low, we can expect a market explosion (not necessarily a drop inthe market), for a large move is possible in either direction.The Chicago Board Options Exchange (CBOE) publishes twovery important vol