Accredited Investing Education

Using Volatility Crush to your Advantage

As a buyer and seller of options contracts, I must be knowledgeable of how the premium on these contracts is derived and will change during a trade. The
greeks associated with my options tell me how their premiums will change as the equity price fluctuates (delta and gamma), as time passes (theta) and at
times perhaps most importantly when implied volatility changes (vega). Knowledge of these variables can take a trade from good to great and can help avoid
some common traps in working with these instruments.

Implied volatility (IV) – as represented by the greek vega – is one very important component in the options’ extrinsic value (risk capital) portion of the
premium. When IV is relatively high, the options market is pricing in the potential for a great deal of fluctuation in the underlying equity’s price during
the lifetime of the option. This causes option premiums to inflate. Conversely, when IV is relatively low, the options market is pricing in the idea that
the equity will move much the way it has in the past – nothing unusual expected – and premiums on options will be lower. What causes such changes in IV?
News! It can be the sort of news that affects the market as a whole or equity specific news. Many – if not most – equities share a repeatable pattern when
it comes to IV. Ahead of a company’s earnings announcement, IV will typically rise – potentially dramatically – as the options market attempts to price in
the sort of wild, quick movement that may occur in the price of the shares as a result of the “report card” given in the earnings information. This swell
in IV is seen most dramatically in the options series – whether weekly or monthly – that contains the earnings announcement. Once the announcement is made,
the options experience IV crush – a dramatic deflation of the IV balloon of premium. Those options that saw the biggest swell in premium are the very ones
that crush the most dramatically. When it comes to buying and selling options, the idea is to buy options when IV is low and likely to go higher and to
sell options when IV is high and likely to go lower. Is there a way that we can construct a spread trade to take advantage of this differential in IV
crush? There is – the calendar spread.

The idea behind a calendar spread is to create a trade that benefits as an equity moves slowly in the direction of the long option while allowing the
premium decay from the shorter term short option to provide both a hedge as well as additional profit in the trade. The shorter term sold option
experiences greater premium decay than does the long option. An interesting opportunity presents itself when an equity has weekly options available.
As you might imagine, IV can get very high for the weekly options containing the earnings report compared to options further out in time. These short term
options will experience both dramatic IV crush as well as excessive theta decay since they expire in a matter of days. If you have an equity where the
options market is pricing in a great deal of price movement in the short term and the equity does not move much, you can have a great setup for a
high reward calendar spread as the IV crush on the short term short option is dramatic and provides profit to your trade quickly. Let’s look at a recent
example with Home Depot (HD).

Home Depot announced earnings recently on August 20, 2013. The Friday before the earnings event the implied volatility constellation showed a very
favorable skew for this trade as seen below:

As you can see, the weekly options for the week of August 23 containing the earnings event show the spike in IV as compared to others further out in time.
I constructed a put calendar on Home Depot with the idea that shares of HD wouldn’t move dramatically after the report and the IV crush of the short term
short put would carry profit in the trade. Here’s a snapshot of the analytics on the trade provided by TradeMonster:

When I ran these analytics, I crushed the IV on the short term option to a greater degree than the crush my longer term November would experience.
Assuming no equity movement, you can see the dramatic profit on the trade provided by this crush. This is what actually occurred by the end of the trading
day on the day of earnings:

As you can see, IV crushed on the front month from just over 37% to 27% while shares of HD slid slightly to $74.29. I was able to close out the trade for
the $2.43 credit. My original debit was $1.94 so this represented a profit of $.49 on my $1.94 debit – a return of 25% in less than two trading days. The
trade was slightly less profitable than my forecast due to less IV crush than I priced into my calculations. HD did precisely what I expected – little
equity movement with dramatic IV crush on my short option. I consider this a “riskier” application of a calendar spread due to the fact that you could get
large equity movement causing the need for immediate adjustment. I don’t utilize this on all the equities I trade. It works best when the options market is
pricing in a great deal of short-term price fluctuation but the equity moves less than expected. This is definitely an interesting one to practice!

Karen Smith
OptionsANIMAL Instructor

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