In a recent article targeting options traders, I came across advice that echoes counsel I've given on these pages. When choosing trades, avoid trades that makes you constantly uncomfortable. Learn the kind of trader you are and the risk (margin or buying power) that you can tolerate without feeling undue discomfort. That tolerable amount of money to put at risk might be much smaller than your account size. You might have a $500,000 trading account, but that doesn't mean you'll feel comfortable with $200,000 at risk in five separate strategies. Even if you're comfortable with a trade type and trade size, market conditions might cause discomfort.
Let's look at a specific situation, starting with a chart comparing the six-month implied volatility and historical volatilities for CPWR, from OptionsXpress. For newbies, think of implied volatility as the spot volatility. Implied volatility is one of the inputs into an option's price.
OptionsXpress Chart Comparing Implied and Historical Volatilities for CPWR:
CPWR showed up on an OptionsXpress scan for stocks with a high IV/HV ratio, high implied volatility compared to historical volatility. The chart reveals that implied volatility is at the higher end of the volatility range over the last six months. A glance at an earnings schedule shows that the company isn't due to report until toward the end of April, a month away from the March 22 date when this article was roughed out in preparation for publication. That earnings report would come out after April expiration.
The comparison of implied and historical volatilities tells us that CPWR's options may be expensive. I have not routinely watched CPWR's options so can't verify that is true. Let's look at an at-the-money straddle priced that March 22 afternoon. A straddle consists of a long call and a long put. The idea is that the stock would move big enough that the profitable option more than makes up for the purchase price.
Upside and downside breakevens for this trade at expiration are at 11.52 and 13.48, or actually, a little outside those BE's by the amount of the commissions. If CPWR is anywhere between those BE's as the expiration approaches, that "T+0" line will sink into the red valley between them. Because earnings are the week after expiration, it's possible that implied volatilities will stay high fairly close to APR's expiration, but if so they'll collapse into that valley quickly as expiration grows near.
Because the implied volatility is already high compared to the historical norm, it's possible they'll sink even sooner. The following chart shows what would happen if the implied volatility was to sink about six percent soon after the original chart was snapped on March 22, bringing it about to the middle of the range for historical volatility over the last six months.
Chart with Implied Volatility Lowered:
The black today line sinks rather quickly. A quick way to remember the effect that a change in implied volatilities will have on the today line is that a lowering of implied volatilities will bring that line closer to the expiration graph, and a raising will often bring it away from that expiration graph.
Although the approaching earnings throws a wrinkle into the study, traders should know that the options for a straddle may well be more expensive than the norm when implied volatilities are near the high of the last six-month or longer period. That doesn't mean that expensive options can't get more expensive, inflating the value of the options you bought, or that a high IV/HV ratio can't go higher. However, the trader would have to have a strong belief through a study of the chart or a thorough knowledge of the stock's behavior that the stock was due for a move big enough to bring the expensive straddle into a profit zone.
Price Chart, Snapped on March 22:
Remember that this chart was snapped on March 22, so prices are not current. This is not a trade recommendation but rather is an examination of a trade that might best be avoided due to market considerations.
When we look at the boundaries CPWR would have to extend past at expiration in order for the trade to be profitable, we see potentially strong support near the $11.52 mark. Reaching beyond the upside breakeven would require quite a stretch. An examination of the behavior of CPWR near earnings show that it can make quite dramatic moves. Perhaps the trader would at first theorize that the $98.00 plus commissions and slippage cost paid for the trade was worth the risk, but that trader would have to remain aware that earnings come after expiration, not before it. The last two earnings cycles, CPWR tended to be pinned near a certain price in the week or two leading into earnings.
The point? These days, I'm a plodder among options traders. I tend to be a trader who likes one strategy month after month. That would drive other traders batty. Traders who like to jump around--who need to jump around to keep from getting bored and overtrading--should not ignore volatility considerations when considering a new trade. All I've covered is a rudimentary introduction to the idea that high IV/HV ratios could mean that options are expensive, and market conditions may not be ripe for a trade such as a straddle or strangle. That type of trade may not feel comfortable in a situation when options are expensive and earnings are approaching. That might be a trade to avoid unless the trader knows this stock's behavior and the way implied volatilities change as expiration and earnings approach.
Examining volatility issues may lead traders to avoid even a favored trade during certain market conditions. For those not familiar with volatility issues, Jeff Augen's books have provided help for many, although they're dense. I've personally made it through only one, a workbook type book that I thought quite good.
The bottom line is that traders should avoid trades that make them uncomfortable, either due to a too-large size, a need to adjust too frequently, or market conditions. For example, unless seasoned and familiar with the underlying's behavior, traders should perhaps avoid a trade that is a net buy of options when options are expensive and IV's may be due for a pullback.