How Option Volatility Can Increase Your

Probability of Success
by Joshua Belanger
One of the biggest reasons investors are scared off by options is because
they fully dont understand them. Its true, one of the toughest concepts to
grasp for equity investors transitioning into options investing is
understanding how option values are derived.
With stocks its very simple to understand, for every dollar the stock price
rises you lose $1 per shareon the flip side for every dollar the stock
price drops you lose $1 per share. This is referred to as a linear
relationship.
Now, when it comes to options investing the relationship is non-linear.
You see, not only are options influenced by the price movements of the
underlying stock, but time to expiration, volatility and option strike price
selection all play a major factor.
For example, there are cases when a stock price can rise and the call
options lose value. If you didnt know better youd think that options
were manipulated by market makers.
However, this isnt true.
For an in depth explanation, feel free to go back to The Ugly Truth about
Buying Options and watch the How To Buy Options For Better
Results inspired from that article.
Moving on, the most interesting component pertaining to how options are
priced is implied volatility. But before I get into that, its important to give
you a little insight into options pricing theory.
Options are priced using a probability model. One of those assumptions in
that model is that equity prices follow a lognormal distribution.

In theory, equity prices cannot have negative prices and can rise
exponentially higherbecause of this, the skew is shifted more towards
the right. Now, the normal distributionwhich is commonly referred to
as the bell-curve is used to model returns.
For the most part, options are priced using the Black-Scholes formula or a
variation of it. The (Black-Scholes formula is only suitable for European
Style Options.
European Style options are simply options that can only be exercised at
expiration. Now, American Style options can be exercised at any time
before the option contracts expire.)
With that said, on my thinkorswim platform, the Bjerksund-Stensland
model is used because its able to get more accurate prices for American
options. However, the formulas are very similar.
Furthermore, the Black-Scholes formula uses the normal distribution in
their model. (But the inclusion of exponential functions makes the
distribution lognormal.)
If this isnt clicking yetjust take a look at this image below:

Option theory assumes that daily returns will follow a normal
distribution (outlined in red, the actual distribution is in blue).as you
can see, this isnt a perfect fit.
The next term you should familiarize yourself with is standard
deviation.
Now, standard deviation is the statistic used to measure the amount of
variability (randomness) around the mean (the highest point on the bell-
curve). The option pricing model uses standard deviation to measure
volatility.
In the above example we looked at a one year chart of daily returns (in %
terms) for Apple. The chart compares the theoretical normal distribution
to the actual distribution.,
The mean was 0.2% and the standard deviation was 1.37%.

So if the average daily return was 0.2% during the sample period, 34% of
the daily returns would be within the one standard deviation of 1.37%.
Now if you went from -1.37% to 1.37% that would include 68% of the
daily returns.
Lets assume that Apple is trading at $102 per share. A (+/-) 1 standard
deviation move would encompass about 68% of the normal distribution.
The theory is saying that on any given day,
Apple stock price will be within a +/- $1.40 move 68% of the time (given
the stock price at $102).
Now, to figure out what a (+/-) 2 standard deviation move would be,
simply multiply (+/-) $1.40 by 2. This is equal to (+/-) $2.80. According to
our sample, Apple stock price moves will be within a (+/-) $2.80 move on
a given day 95% of the time.
Lets take a look at another stock, Tesla Motors.

During this sample period, the the mean was .2% and the standard
deviation was around 3.44%.
If Tesla is trading at $279 per share, 68% of the time, the daily price move
will be within (+/-) $9.60 according to the normal distribution.
Takeaways So Far
Options are priced using a probability model.
The option pricing formula assumes that returns are normally
distributed.
Standard deviation is used as a volatility measure.
Implied volatility is the direct measure of how much the market
thinks the underlyings price might change. Its a reliable metric to
predict the range of future price changes.
How good are the assumptions?
Stock returns do not follow a normal distribution. If you look at the Tesla
chart above, youll notice daily returns around the mean occurred more
often than the model anticipated. In addition, there were several more
outsized returns than the model anticipated.
Looking at the Apple chart, there were more negative than positive
returns. Both charts experience fatter tails, notice at the end of the
normal distribution the odds of extreme price moves are very small.
However, in reality, extreme price moves in stocks happen a lot more
often than the normal distribution assumes. A quick look at the Tesla
chart above will show you what I mean.
Heres another assumption:
The option pricing formula assumes that volatility is constant. In practice,
youll notice that each option strike has its own volatility.

In fact, option volatility or implied volatility is not derived from historical
price returns.Implied volatility is derived from the flow of options.
Why does implied volatility vary amongst option strike prices?
Well, for one reason, market participants know that stock price returns
dont follow a normal distribution. As youve seen from the previous
charts abovestock price returns have fatter tails.
Also, one of the driving factors behind implied volatility is supply and
demand. For example, On September 12, 2014, there were some rumors
circulating that Google might have an interest in Ebays PayPal.
The thought was that Googles Wallet was sort of a failure and the
emergence of Apple Pay would take market share away from them. Of
course, this was all speculation, but that didnt stop the option market
participants from placing their bets.
On that day, there were nearly 220,000 Ebay options traded4.3x usual
options volume. The 30 day at-the-money implied volatility jumped 5.6
points to 27.9%. This increase in option volatility was driven by the
demand for option premium.
By the way, in the above examples, we were looking at volatility in terms
of daily returns. However, options are expressed in annualized returns.
To convert annualized volatility to daily volatility, take the annualized
volatility and divide it by the square root of the number of trading days
(252). For example, .279/15.87 = .0175 or 1.75%. In EBay, a one standard
deviation move is a +/- 1.75%.
As mentioned, demand for options shifts implied volatility. The more
demand for an option, the more expensive the options becomeon the
flip side, if there is large selling in options, volatility drops.
What else?
Well, uncertainty causes option volatility to also increase. This typically
happens ahead of an earnings announcement, a company product
announcement, pending FDA announcement etc.
Implied volatility can spike off news rumors, like the one mentioned with
EBay. It can also spike due to rumors or chatter like an activist might be
involved or the stock has become an M&A target and a whole bunch of
other stuff.
Bottom line, uncertainty creates option volatility to increase.
Of course, the price action in the stock could also drive speculators to pay
up for options in fear that they might miss the next big move. For
example, GoPro has risen from $40 per share to nearly $70 over the last
month.
On, 9/11/14, The October $100 calls were $0.35 bid at $0.40 ask. Thats
another 40% plus move needed in a months time! Could the stock really
go from $40 to $100 in two months? Sure, but you have to think that
some investors are feeling euphoric.
To be honest, some of the best opportunities are those in which you can
spot that euphoria. You see, when Im selling option premium, I try to find
trades in which the market has to do something mind-blowing to beat me.
One of these opportunities happened recently ahead of the big Apple
product announcement. Now, this was heavily anticipated and some
believed it was going to be the biggest product launch theyve had in
yearsthere was a ton of rumors on what they might be rolling out.
I think everyone knew that they would introduce the newest version of
the iPhone. Other speculation was on an Apple TV or some kind of
wearable. There was a lot of buzz around it in fact, it was even reflected
in the way the options were priced.
With the stock trading at $98.38 on the day before the announcement, the
$99 straddle was implying around a +/- $4.20 move by Friday.which
was over a 4%.
Keep in mind, ahead of this announcement there was a great degree of
uncertainty, how would the market react to their new products? Was this
going to be a game-changer like the iPhone or iPad?
One thing was sure, once the news was fully digested, implied volatility
was expected to come in pretty hard.
By the way, if you are stuck on what the implied move meansmake sure to
review Dont Trade Earnings Before You Read This
I was looking for a trade that benefits from time decay and the inevitable
decrease in implied volatility.
In this opportunity, I was looking at this a short strangle:

Note: These are the closing prices of the strangles on August 8, 2014
The first trade was selling the $102 calls and $94 puts for a premium of
$1.36 (weekly options expiring that Friday)
This means my break-even points would be $103.36 (an all-time high)
and $92.64 (September contracts expiring in 11 days)
The second trade was selling the $103 calls and $92.5 puts for $1.51.
This means my break-even points were 104.51 and $91
Technically, my risk is not defined because Apple could theoretically go
to infinity or zero
However, weve already witnessed how accurate theory is.
Some of you might be thinking that selling strangles is very risky. In some
cases, it can be.
However, youve always got to look at the stock youre involved in. For
example, there is always overnight risk, the stock could have a huge gap
up or down.
So Ill walk you though my thought process
Apple is a $600 billion dollar market cap company that actually makes
moneyfor the stock to have a massive gap up or downa lot would need
to happen. Its not like Apple is an M&A target for anyonethey are the
ones who do the acquiring.
Even though my risk was theoretically unlimited, I really didnt think
there was a lot of overnight and pre-market risk.
Also, Apple is a lower priced product after its split a few months ago. That
means the naked options will not take up as much buying power as it
would have before when it was a $600 stock.
In this case, I was expecting implied volatility to come in hard and
fastthis is not something I was planning on holding till expiration.if
things go as planned, Id be out in less than 24 hours.
Well, on September 9th the announcement was madeApple displayed a
bigger, new iPhone, Apple Pay and the Apple iWatch. Some people loved
the conceptssome people hated them.
The stock moved from being negative to positive to negativeresulting in
a -$0.37 change in the stock price from the previous day.
But guess what? The option premiums got absolutely crushed. At the end
of the day, the price of the first strangle (-1 102 call/ -1 94 put) could
have been bought back for $0.34 and the price of the second straddle (-
103 call/ -1 92.5put) could have been bought back for 73 cents.
As you can see, my bet was not on the Apple product announcement as
much as it was on how the option participants were expecting the Apple
announcement to play out. Like they say, a good poker player doesnt play
his cardshe plays his opponent.
Why get out that day and not look to capture all of the premium? Well,
this particular play was based off the idea that the option market was
overestimating the impact of the product announcement.
I also knew that after an event, the uncertainty disappears and implied
volatility drops. Once that happened there was no reason to be in the
position.
I achieved the best return on capital in the shortest amount of time with
the highest chances of success. Staying in that position changes my risk
dramatically and exposes to me to gamma risk.
A common reason why short premium option trades dont work for
investors or traders is because they sit in them too long trying to get
every penny possible. This is why I wrote, Greater Profits In Less Time
On Your Option Trades
Looking at the longer term implied volatility chart, you can see how
quickly the volatility came back in. In regards to those weekly options, the
ATM straddle went from 44% to 27% in one day.

Its vary rare, but sometimes high implied volatility is justified depending
on the underlying and youll want to avoid.
However, if you want to create long term success with options, especially
in todays market where euphoria or fear take over. Its situations like
that, which make selling option premium allows you to get the laws of
probability on your side!
Key Takeaways For Your Success
Unlike options theory, option volatility or implied volatility is a
function of supply and demand
Uncertainty or binary events causes implied volatility to move
higher
After an event, implied volatility gets sucked out like a vacuum
because the uncertainty disappears
Selling strangles does not make sense with every stock, risk defined
strategies like iron condors and butterflies could more appropriate
for your account and risk tolerance.
Theoretically risk is not defined when selling strangles. However,
given the right market conditions and a stock that isnt overly
vulnerable to overnight or gap risk.. it can be a very profitable over
the long term.
Try to identify why the implied volatility is high and if you feel its
justified to take on the risk.
When selling premium its important to not over leverage. For a
review, read Why Size Matters; Especially In Options Trading
Make no mistake about it, investing successfully with options is not easy.
However, part of becoming profitable is identifying opportunities and
then trying to take advantage of them. Situations like this example in
Apple dont happen everydaybut when they do, will you be ready for
them?
When Im entering short premium trades my thought process is that the
market is gonna have to beat me with something exceptional for me to
lose money. With that said, I dont believe in selling premium blindly
without a good reason.
How about you? Do you tend to mix it up between premium buying or
selling? Or do you stick to one method or strategy? Id love to hear your
thoughtsIll be hanging out in the comments section below.


If you enjoyed what you read and you want to continue learning more on how to to become successful in financial markets using options, visit
http://www.OptionSIZZLE.com

You can also download your FREE report that teaches you The #1 Secret On How You Can Find Tomorrow's Best Trades Today!

Joshua Belanger is the founder of OptionSIZZLE.com and his dream is to not only create wealth, freedom & options for himself, but for you as well.


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