One of the biggest reasons investors are scared off by options is because they fully don’t understand them. It’s true, one of the toughest concepts to grasp for equity investors transitioning into options investing is understanding how option values are derived. With stocks it’s very simple to understand, for every dollar the stock price rises you lose $1 per share…on 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 didn’t know better you’d think that options were manipulated by market makers.

1. How Option Volatility Can Increase
Your Probability of Success

2. One of the biggest reasons investors are scared
off by options is because they fully don’t
understand them. It’s true, one of the toughest
concepts to grasp for equity investors
transitioning into options investing is
understanding how option values are derived.

3. With stocks it’s very simple to understand, for
every dollar the stock price rises you lose $1 per
share…on the flip side for every dollar the stock
price drops you lose $1 per share. This is
referred to as a linear relationship.

4. 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.

5. For example, there are cases when a stock price
can rise and the call options lose value. If you
didn’t know better you’d think that options were
manipulated by market makers.

6. However, this isn’t true.

7. 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.

8. Moving on, the most interesting component
pertaining to how options are priced is implied
volatility. But before I get into that, it’s
important to give you a little insight into options
pricing theory.

9. Options are priced using a probability model.
One of those assumptions in that model is that
equity prices follow a lognormal distribution.

11. In theory, equity prices cannot have negative
prices and can rise exponentially
higher…because of this, the skew is shifted more
towards the right. Now, the normal
distribution…which is commonly referred to as
the bell-curve is used to model returns.

12. 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.

13. 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.)

14. With that said, on my thinkorswim platform, the
Bjerksund-Stensland model is used because it’s
able to get more accurate prices for American
options. However, the formulas are very similar.

15. Furthermore, the Black-Scholes formula uses the
normal distribution in their model. (But the
inclusion of exponential functions makes the
distribution lognormal.)
If this isn’t clicking yet… just take a look at next
image:

17. 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 isn’t a perfect fit.

18. The next term you should familiarize yourself
with is standard deviation.

19. 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.

20. 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%.

22. 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.

23. Let’s 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).

24. 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.

25. Let’s take a look at another stock, Tesla Motors.

27. 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.

28. Takeaways So Far

29. • Options are priced using a probability model.
• The option pricing formula assumes that
returns are normally distributed.

30. • Standard deviation is used as a volatility
measure.
• Implied volatility is the direct measure of how
much the market thinks the underlying’s price
might change. It’s a reliable metric to predict
the range of future price changes.

31. How good are the assumptions?

32. Stock returns do not follow a normal
distribution. If you look at the Tesla chart above,
you’ll 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.

33. 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.

34. 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.

35. Here’s another assumption:
The option pricing formula assumes that
volatility is constant. In practice, you’ll notice
that each option strike has it’s own volatility.

37. In fact, option volatility or implied volatility is
not derived from historical price returns.Implied
volatility is derived from the flow of options.

38. Why does implied volatility vary amongst
option strike prices?

39. Well, for one reason, market participants know
that stock price returns don’t follow a normal
distribution. As you’ve seen from the previous
charts above…stock price returns have fatter
tails.

40. 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
Ebay’s PayPal.

41. The thought was that Google’s 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 didn’t
stop the option market participants from placing
their bets.

42. On that day, there were nearly 220,000 Ebay
options traded…4.3x 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.

43. By the way, in the above examples, we were
looking at volatility in terms of daily returns.
However, options are expressed in annualized
returns.

44. 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%.

45. As mentioned, demand for options shifts
implied volatility. The more demand for an
option, the more expensive the options
become…on the flip side, if there is large selling
in options, volatility drops.
What else?

46. Well, uncertainty causes option volatility to also
increase. This typically happens ahead of an
earnings announcement, a company product
announcement, pending FDA announcement
etc.

47. 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.

48. Bottom line, uncertainty creates option
volatility to increase.

49. 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.

50. On, 9/11/14, The October $100 calls were $0.35
bid at $0.40 ask. That’s another 40% plus move
needed in a month’s 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.

51. To be honest, some of the best opportunities are
those in which you can spot that euphoria. You
see, when I’m selling option premium, I try to
find trades in which the market has to do
something mind-blowing to beat me.

52. 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 they’ve had in years…there was a ton of
rumors on what they might be rolling out.

53. 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.

54. 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%.

55. 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?

56. One thing was sure, once the news was fully
digested, implied volatility was expected to
come in pretty hard.

57. By the way, if you are stuck on what the implied
move means…make sure to review Don’t Trade
Earnings Before You Read This

58. I was looking for a trade that benefits from time
decay and the inevitable decrease in implied
volatility.

59. In this opportunity, I was looking at this… a
short strangle:

60. Note: These are the closing prices of the strangles on August 8, 2014

61. 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)

62. 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

63. However, we’ve already witnessed how accurate
theory is.
Some of you might be thinking that selling
strangles is very risky. In some cases, it can be.

64. However, you’ve always got to look at the stock
you’re involved in. For example, there is always
overnight risk, the stock could have a huge gap
up or down.

65. So I’ll walk you though my thought process…

66. Apple is a $600 billion dollar market cap
company that actually makes money…for the
stock to have a massive gap up or down…a lot
would need to happen. It’s not like Apple is an
M&A target for anyone…they are the ones who
do the acquiring.

67. Even though my risk was “theoretically
unlimited”, I really didn’t think there was a lot of
overnight and pre-market risk.

68. 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.

69. In this case, I was expecting implied volatility to
come in hard and fast…this is not something I
was planning on holding till expiration….if things
go as planned, I’d be out in less than 24 hours.

70. Well, on September 9th the announcement was
made…Apple displayed a bigger, new iPhone,
Apple Pay and the Apple iWatch. Some people
loved the concepts…some people hated them.

71. The stock moved from being negative to positive
to negative…resulting in a -$0.37 change in the
stock price from the previous day.

72. 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.

73. 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 doesn’t play his cards…he
plays his opponent.

74. 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.

75. 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.

76. 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.

77. A common reason why short premium option
trades don’t 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”

78. 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.

80. It’s vary rare, but sometimes high implied
volatility is justified depending on the
underlying and you’ll want to avoid.

81. However, if you want to create long term
success with options, especially in today’s
market where euphoria or fear take over. It’s
situations like that, which make selling option
premium allows you to get the laws of
probability on your side!

82. Key Takeaways For Your Success

83. • 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.

84. • 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.

85. • “Theoretically” risk is not defined when selling
strangles. However, given the right market
conditions and a stock that isn’t overly
vulnerable to overnight or gap risk.. it can be a
very profitable over the long term.

86. • Try to identify why the implied volatility is high
and if you feel it’s justified to take on the risk.
• When selling premium it’s important to not
over leverage. For a review, read Why Size
Matters; Especially In Options Trading

87. 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 don’t
happen everyday…but when they do, will you be
ready for them?

88. When I’m 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 don’t believe in
selling premium blindly without a good reason.

89. How about you? Do you tend to mix it up
between premium buying or selling? Or do you
stick to one method or strategy? I’d love to hear
your thoughts…I’ll be hanging out in the
comments section below.

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