Last week's Option 101 article discussed extrinsic value or time value, as it's sometimes called. We learned that time value can be a misnomer because extrinsic value is also impacted by changes in implied volatilities. It's also impacted by changes in interest rates, but we haven't had to worry about that much for the last several years.

If implied volatilities are high, options are likely to be expensive because the extrinsic value expands. How do you know when you're buying an expensive option?

The RUT's Volatility Index, the RVX:

When the RVX was hitting the top of that channel on October 8 and 9, the RUT was dropping hard. Options were likely expensive. Even call options likely saw their extrinsic value expanding due to the higher implied volatilities. The call buyer who thought the RUT was going to turn around was likely rewarded anyway, even though out-of-the-money calls probably had some extra extrinsic value in them, too. That's because the RUT's rebound was hard and fast. The rapid climb soon made up for the adverse effect of any decrease in implied volatilities. A call buyer who spent $10.70 to buy a slightly out of the money 1050 OCT 13 RUT call near the close on October 9 would have been rewarded when that call went into the money the next day and jumped up to a $24.25 midprice near the close the next day. Profit would have been ($24.25 - $10.70) x 100 = $1,355 minus commissions and slippage. The extrinsic value had shrunk, from $10.70 near the close on October 9 to $5.14 near the close on October 10, but the 2.14 standard-deviation rally that next day more than made up in delta-related gains for any value the dropping implied volatilities stripped away.

We're seldom going to see 2.14 standard-deviation rallies, however. How could a trader who believed that the RUT would bounce the next day have gained some protection from a vol crush, if a bounce should be more modest? For just a little more money than the $10.70 cost of the call used in our first example, that trader could have bought two ATM OCT 13 1040/1050 call debit spreads for $11.00 total, buying the 1040's and selling the 1050's. Vega--the risk due to implied volatility changes--would have decreased to 0.48 from the 64.56 for buying the 1050 OCT 13 RUT alone. Theta, the decay related to time passing, would have been reduced to -8.15 from the -73.90 for just buying the 1050 OCT 13 RUT call. Therefore, volatility- and price-related risks were reduced.

Of course, the opportunity to benefit from a rabid rally would have been reduced, too. At expiration, the gains would have been capped at (2 contracts x $10.00 spread between calls - $11.00) x 100 = $900 minus commissions and slippage. Before expiration, any potential gain would be less.

What would have happened if this position had been opened near the close on October 9, the same time the call in the first example had been purchased? How much profit would have been available near the close the next day?

The OptionNET Explorer charting system calculated that, after commissions of $1.25/contract, the one-day profit would have been $590.00. That paltry $590.00 makes one wince when compared to the potential gains from that 2.14 standard-deviation rally on October 10, but 2.14 standard-deviation rallies are rare.

Figuring out whether implied volatilities are high are low is relatively easy when you're talking about a big index such as the RUT or SPX, when you can use the RVX or VIX as proxies for implied volatilities. What if trade IBM or another stock? Brokerages or charting programs often include charts that show the track of the implied volatilities for various securities. Here's one from OptionNET Explorer, for example, tracking implied volatilities and price for IBM on the same chart.

IBM, Volatilities and Price:

When I used OptionsXpress as my brokerage, I was able to look at a chart that plotted implied volatilities versus historical volatilities. Check with your brokerage platform to determine if such charts are available to you. Get directions on how they work as they vary from platform to platform.

I hedge my butterflies against a strong upside move by flattening deltas with either long calls or call debit spreads. If implied volatilities are near the bottom of half of their range for the year, I tend to buy deep-in-the-money long calls. However, even those deep-in-the-money long calls plump up in price somewhat when implied volatilities rise too sharply. I'm accustomed to paying something not too far from $116.00-$119.00 for long calls with a 95 (or 0.95, depending on the quote source) delta. However, when implied volatilities get up too high, I might be asked to pay $130.00 or more for the same delta protection. When implied volatilities get too high, therefore, I switch to buying long call debit spreads.

What if you want to take advantage of expensive options by scanning for them, selling them and waiting to collect your profit when implied volatilities dip down toward normal? I would urge caution. First, you have to have the belief that implied volatilities are high and are likely to steady or decline. Sometimes, if you're running scans like this and are unfamiliar with the underlyings that are located, you may be unaware that one of the identified stocks is a pharma company with rumors circulating that the FDA is going to kick back the results of its last drug trial for more clarification. The company may be about to report earnings and rumors may be circulating that they won't be good.

However, if you have lotto winnings you'd like to invest in a lotto play, such scans can be conducted. Again, check with your brokerage because each one differs in the types of scans that can be performed and the different parameters that can be input. When I did feel like such lottery-type plays, I wanted companies with a certain average daily volume and price threshold (no penny stocks), for example. Again, these articles about the basics of options trading are just that. I'm throwing out ideas for further research, but I'm far from another McClelland, Augen, or Bittman.

Linda Piazza