As option traders, volatility is one of the most important metrics that we have to monitor so I thought I write a short post about it.
What is the volatility?
It's a complex statistical calculation that measures the risk associated with every stock. Basically every single stock, ETF, futures have their own volatility based on more factors then I could come up with, but the most obvious ones are: industry, company specific news or dealings, location, timing.
Some industries are more volatile than others, therefore we must manage them differently. For example, we can't look at pharmaceutical companies the same way as precious metals. Pharmaceutical companies can experience significant price fluctuations, which are caused by, for example, promising new formulas or approval/disapproval of a new medicine. The covid era was a perfect example where some pharmaceutical companies skyrocketed as they managed to come up with a promising vaccine.
Company specific news
Let's assume a pharma company comes up with a very promising formula that may cure cancer. Immediately the stock price is expected to jump and due to the sudden price movement the volatility also jumps up. Or another example would be if a software company managed to secure a long-term contract with the government of a major economy.
Needless to say that some geographical areas are more risky not just from the humanitarian but also from economics point of view too. Therefore, companies that operate in more risky locations will naturally have higher operational risks resulting in higher volatility.
This is probably the most important of the above mentioned attributes. The most obvious timing risk is the quarterly earnings of a company. Every publicly traded company has to report their earnings quarterly, which gives traders the opportunity to re-assess their view on the company's stock price. It's almost like a toddler who keeps running all over the place and their mother brings them back every 3 minutes.
As option traders, we want to take advantage of the fluctuations in the volatility by selling options when the volatility ranking is high, which means that the volatility of the underlying is higher than usual.
Approaching earnings is a perfect example as before every earnings the volatility goes up high and drops straight after earnings. Let's take a look at the most recent Nike earnings: as we can see, the share price before the earnings on March 21 was around $129.53. Right after the earnings the share price jumped to about $136 but went all the way up to $139.00. At the end of the trading day on March 22 the share price stopped at $133.09.
Nike 30 Minute Chart
Now let's take a look at the stock from the volatility perspective: We can see that the volatility (look at the middle of the bottom two lines on the below diagram) was around 80 leading up to the earnings announcement, but the following day it dropped to about 30. This means the option prices also dropped significantly irrespective of the price movement.
Nike Daily Chart and Volatility
Finally, let's take a look at what happened to the April $120/150 strangle (sell put option with $120 strike and April expiry + sell call option with $150 strike and same expiry) that we could have traded: The put option was trading at around $2.62 before the earnings and dropped to about $0.61 after the earnings, while the call option was trading at $0.90 before the earnings and dropped to $0.30.
Nike April $120 Put Prices
Nike April $150 Call Prices
So if someone traded the above mentioned strangle then they would have pocketed $2.01 on the put side and $0.60 on the call side totalling $2.61 profit in less than 24 hours. That's an impressive return.
It is worth noting that even though share price went up from $129.53 to $133.09 (looking at the prices at market close), the call option value dropped significantly purely because of the massive volatility drop, which is often called 'Volatility Crush'.
I trust that this post helps you better understand the importance of volatility when trading options.
If you have any questions, please feel free to comment.