Last week we discussed the basic principle of managing risk when trading options: calculating probabilities so you can find and place winning trades with more confidence. (If you missed it, go back and read it now. It’s critical to have a strategy in place if you want to consistently earn income trading options.) In today’s article, we discuss volatility; specifically, how implied volatility can help us decide whether a trade is worth our time and money – or not.
The role of implied volatility in options trading
Options have two characteristics: intrinsic value and time. In order to price an option correctly, you need some historical context based on past activity or behavior. This is where implied volatility comes in. What is the expected move as calculated based on a formulaic model? Some models use Black/Scholes to price an option. However, this does not take time into consideration. Without looking at time, even the most precise model may not price an option correctly.
When an option is priced based on historical patterns, the price could be very high if a stock has a history of big moves.
Let’s say we are in front of an earnings report for Chipotle. We know the stock is expensive ($1,900 per share) and that it has made very large moves up and down following the last two earnings reports. We may see an option at the money trading a 2% of the stock price, or $38. One contract would cost you $3,800. The market is looking for a big move higher, so implied volatility is high. Is it worth it to risk so much capital on a single play?
So now let’s look at the timeframe. The more time you have, the better chance you have to make it to your strike price and an eventual payoff. However, you’ll pay for that time with a higher option price. Again, is it worth it?
Look at volatility through a risk management lens. If volatility is high but a stock is unlikely to move much, the option is overpriced. The stock may make a decent move higher, but if it doesn’t, your losses could be substantial. Can your portfolio absorb a large loss?
In my book, the risk is not worth while. The odds are not in your favor. In fact, you might as well just play roulette in Vegas.