How To Trade Option Skew

Hot Option Plays: Another Fat Finger Trade?

With mixed economic data, Claims came in little worse than expected, the world’s largest CEO resigns, volatility is still high and the market bounced and pulled back after someone over in Europe decided it was a good time to cram the DAX (which will be known by tonight as the fat sausage finger trade). At this stage I am trading strategies that take advantage of the market volatility like in Gold, GCZ11 holding 1750, by using ratio spreads. Here’s an example — if you are a bull in Gold, buy one OTM put and sell 2 further OTM puts in the same expiration month. This strategy takes advantage of that skew which is in the Gold market after the parabolic rise this last week. The risk in that strategy is if the Gold market is below the strike of the option you sold then you will start to get long Gold. This is a more complex and sophisticated trade so go to our Education Center and read up on this strategy. I am also putting on some credit spreads in the Financials, currently working a WFC credit strategy, again trying to take advantage of the big volatility in these names. See you After Hours.

Stock market averages are lower on a busy news day Thursday. Apple Computer shares surged 25 percent Thursday morning and were recently up 6 percent after Buffett’s Berkshire Hathaway announced plans to invest $5 billion into the bank. The only economic stat of the day was a disappointment. According to the Labor Department, filings for jobless benefits increased by 5,000 to 417,000 in the week ended August 20. Economists were looking for a decline of 12,000. A sharp reversal in Germany’s DAX is also weighing on Wall Street. After trading higher early, the benchmark tumbled 4 percent in afternoon trading and closed down 1.7 percent. The intraday volatility across the Atlantic seems to have spilled over into US trading and the Dow Jones Industrial Average is down 175 points through midday. The tech-heavy NASDAQ lost 44.4. CBOE Volatility Index (.VIX) jumped 3.95 to 39.85. Overall options volume is running about the typical levels, with 5.1 million calls and 5.9 million puts traded across the exchanges through 12:30pm ET.

Understanding Volatility and Its Impact on Options | StockTwits U

According to Dictionary.com, volatile is defined as “tending or threatening to break out into open violence; explosive; changeable; mercurial; tending to fluctuate sharply,” which describes our financial markets over the past month.

Let’s briefly define market volatility and then offer a few ideas how investors can benefit from such market conditions.

Historic & Implied Volatility

Volatility as it relates to options markets is the fluctuation in the market price of the underlying security.It is important to distinguish between the two most common types of volatility: historical and implied. Historical volatility is just that, a statistical measure of how an underlying instrument has moved in the past, usually calculated on an annualized basis, but measured in other time periods too. Be aware of what your time calculating historical volatility covers. Implied volatility, which is a characteristic of the only options, is forecast by all market participants of how an underlying instrument will move in the future. The higher the market’s implied volatility the greater the future expected movements.

Implied volatility is a key element in the time value portion of an option’s premium. When implied volatility goes up, call and put prices go up. When implied volatility goes down options prices go down.

Let’s look at one generic example of how a changing implied volatility level can affect option prices. We’ll use our favorite underlying, XYZ, valued at $50. To keep things simple, assume the 60 day at the money calls and puts have an implied volatility level of 40 giving both a value of $4. One of the most important pricing components for options is VEGA. Think of vega as THE RATE OF CHANGE of an options price. In our example assume our $50 calls and puts have a vega of .10 which equals 10 cents. So if the implied volatility in the options went from 40 to 41, with the stock still at $50, our $50 calls and puts would both increase in value by 10 cents. If implied volatility dropped to 39% from 40%, those calls and puts would drop in value by 10 cents. This dynamic of implied volatility (“vol”) can have a huge impact on option prices when implieds start to move by 10, 20 and 30%. Rather than the implied vol changing by 1% as in the previous example, assume it changes by 20%. That means vols of 32% if lower or 48% if higher. More importantly, the option values would change by 80 cents each not 10 cents. So those $4 options would be worth $3.20 or $4.80 depending if the implied vol moved up or down 20%.

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