Thursday, October 14, 2010

Implied Volatility, Volatility crush ,stock rally and option pricing

" Checking the IV of an option is also a good way to avoid a trap, which  is known in options trading as the volatility crush. Buying an option with an extremely high IV can be a costly mistake. High IV is often associated with some intense excitement about the underlying stock, such as the rumor of a buyout, FDA drug approval, settlement of a court case, and so on. As soon as the excitement is over, the IV falls back to some more normal level, and the value of the option is "crushed". An option purchased with its IV is high will be reduced to a fraction of its purchase price when the IV suddenly reverts to its mean value." pg 220

The above passage is from Options for the Beginner and the Beyond, an excellent book, on this topic.
0. One has to pick a stock in a rally, to have any certainty of the option price movement. If one is not certain about the movement of the underlying stock, then one is playing casino gambling with options. and that can be very costly if one does not know how to get out with a minimum loss. If one waits till expiration or does not get out with a minimum loss, then options is not for you.
1. One has to always compare the present volatility with the past 1 week, 1month, 2, 3 months and see that it is comparable and the present volatility is not jacked up. When the present IV is artificially up because of some irrational exuberance, the demand of the option increases that does not have any correlation with the underlying stock. An option trader has to first find that such a costly mistake does not happen. This is step number one.
2. One can calculate the ideal price of the option using Black-Scholes formula. This formula needs the present IV for its calculations. With elevated IV, the option price may also come out high so this formula needs to be used after one is certain that the IV in question is rational.
3. My preference is to select a stock in  rally and buy the call option with expiry date of 2-3 months at the least. As is well known an out-of money call option needs to be sold 2-3 weeks in ahead, because the value of the option is all time value and it decrease at the option come closer to expiry date. Any way I would take my profit and get out.
4. To avoid risk one can do this, one can get out of the out-of money option before 3 weeks or its top point of the stock price and get into the call option with in the money. That can avoid risk of losing all the profits gain in the at the money, and close out of money call options. One needs to cash in the profits atleast 2-3 week before expiry.
5. One has to know the behavior of the underlying stock. For example ISLN moved from 25 to 27.5 in 3 days, then usually it has its high point at 28-29, this is the time when the call option at his 30 strike price is at its highest point. When the underlying stock starts to consolidate it goes back to 27-28 range. That is the behavior of uptrend and consolidation in a rally.  This is when the option price of say 4 week expiration out of money option may decline almost 40-50% from its peak.
6. What I would do is Calculate the rational price of the option at 29, and it gave me 2.8 with the option calculator. I would put the limit price to sell at 2.5 or so then sell it and get out with 130% profit. I bought it at 0.85 cents per share.
This will be my best entry and exit execution of my life. Never seen this kind of profit taking in my life.
Options are like double edged knife. If one does not know how to select an underlying stock that one bets on, then one is doomed. Options are not for the inexperienced. One has to be a master of trend behavior of the underlying stock.

One can get free data of historical and present IV from

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