A Great Volatility Trade

There is a terrific volatility trade available right now.  I don’t normally comment on current opportunities in this column but this one is simply so good I can’t keep my mouth shut.

As previously written, volatility trading consists of buying cheap options or selling expensive options. It’s called volatility trading because of the way we measure how cheap or how expensive options are – using implied volatility.  Each option implies, by virtue of its current price, and using the option pricing model “backwards,” a certain level of volatility for its underlying.

We gather up the implied volatilities of all the options of a given asset into an average, and we collect a history of daily average implied volatilities. Consequently, this history can be charted. See the chart below for a six-year history of America Online volatilities.

The dashed blue line represents average implied volatility, recorded daily.  When this line is low, as it is now, that means options are cheap.  The solid red line represents the other kind of volatility – called statistical volatility – which is how volatile the price of the stock itself has been at times during the past six years.

The extraordinary thing is how low implied volatility is right now, compared with recent history.  Implied volatility is around 40% right now, compared to a more normal 60% or so.

When options are this cheap (as they are not only in America Online but also in many other top-name tech stocks right now), odds heavily favor the options buyer.  How much of a difference does it make?  Well, to give you an idea, the America Online at-the-money Jan 02 call LEAP, currently priced at 12.25, would be 17.75 if implied volatility was a more normal 60%!

Now, I happen to be of the opinion that the market will repeat a recent pattern of the tech stocks rallying through the winter and into the spring. So I’m going to be a LEAP call buyer.

If you don’t look for such a rally, or if you’re unsure whether America Online would participate in such a rally, the pure (non-directional) way to play this would be to buy a straddle in the LEAPs. 

Either way, I would recommend doing this using LEAPs rather than any of the shorter-term options. Why?  For two reasons. One, you need to give this strategy plenty of time to play itself out.  Who knows?  It might take a couple of months or more. Two, longer term options have higher vega – or volatility sensitivity. So when implied volatility goes up again, your options will respond better.

When implied volatility returns to ~60%, your options will have expanded to more normal premiums. That would be the time to close the position. Also helping the position would be any significant price movement in the underlying. And it would be very reasonable to expect this.  In the chart, note how often statistical volatility spikes to 80% or higher!

My model computes a 100% probability of profit on this trade if implied volatility rises just 10 percentage points (to 50%) within the next three months. Simply a terrific trade!