Contrary to popular investing belief and outdated content, volatility creates opportunities… especially in the options market. In How To Profit From Option Volatility, I discussed how options theory differs from practice…and how implied volatility plays a factor in that. One of the points touched in that article, was how uncertainty drives option volatility higher. Sometimes this elevated options volatility is warranted…but many times it’s not. For example, I know that drug stocks tend to have very high implied volatility levels…however, I also know that they can move a lot (in either direction)…making it hard to justify ever shorting premium in these names. On September 12th, 2014, there was 20 times usual options volume in Avinir Pharmaceuticals Inc (AVNR). The 30 day implied volatility jumped from 91.9% to 99.19% when the stock was trading around $6.74. The options market was implying around a 29% move in a month.

1. How To Successfully Use Option Volatility
To Trade Binary Events

2. Contrary to popular investing belief and
outdated content, volatility creates
opportunities… especially in the options market.

3. In How To Profit From Option Volatility, I
discussed how options theory differs from
practice…and how implied volatility plays a
factor in that.

4. One of the points touched in that article, was
how uncertainty drives option volatility higher.
Sometimes this elevated options volatility is
warranted…but many times it’s not.

5. For example, I know that drug stocks tend to
have very high implied volatility levels…however,
I also know that they can move a lot (in either
direction)…making it hard to justify ever
shorting premium in these names.

6. On September 12th, 2014, there was 20 times
usual options volume in Avinir Pharmaceuticals
Inc (AVNR). The 30 day implied volatility jumped
from 91.9% to 99.19% when the stock was
trading around $6.74. The options market was
implying around a 29% move in a month.

7. Sounds pretty overzealous right?

8. Well, the following Monday, AVNR announced
positive Phase II trial results on their Alzheimer’s
disease drug. The stock traded over $13 per
share…up over 90% ! And get this…option
volatility spiked from 99.19% to 128.2%

9. By the way, detecting this kind of options
activity is covered for you in full detail in The
SIZZLE Method Report. It’s your nuts and bolts
guide teaching you my process how to use
unusual options activity to generate winning
trading ideas.

10. Those who bought call premium were heavily
rewarded… while those who sold call premium
got roughed up pretty bad. These type of plays
are high risk/high reward…sort of like gambling
and not suitable for most option investors.

11. For option investors, having undefined risk in
( small/mid cap) drug/pharma/biotech stocks
should be avoided. The reason being is that
these type of wildcard catalysts are a dime a
dozen.Literally, coming out of nowhere.

12. In many of these cases, their options aren’t very
liquid either, the difference between the bid/ask
is sometimes greater than 50% Slippage is
something you must limit as much as possible if
you want to be profitable. For a more detailed
explanation refer to How You Might Be Losing
Money On Your Option Trades

13. Shorting naked premium without a justifiable
reason can be a very costly mistake. Without a
game plan, the potential of making a mistake
increases substantially. This is probably a reason
why so many option investors are scared to take
the other side of the buy order.

14. One reply to How To Profit From Option
Volatility was this from, @zzbar on twitter:

16. I get it…sometimes you enter a position and it
goes horribly wrong…you get frustrated, upset
and wish you never got involved with it in the
first place. Believe me, it’s happened to me
before and I’m sure to a whole lot of other folks.

17. However, there’s ways to reduce the impact of
these type of losses…by respecting the power of
leverage and sizing your positions accordingly.

18. My response to @zzbar was just that idea.
Keeping risk levels small is one way not to lose
your shirt. Check out Why Size Matters;
Especially In Options Trading for more on the
importance of position sizing.

19. Also, focus on opportunities that increase your
likelihood of success by selling premium where
it feels like the option market is grossly
overestimating the implied or expected move.

20. For example, in How To Profit From Option
Volatility, we discussed selling a weekly strangle
in Apple before their latest product
announcement (iPhone 6, iOS 8, iWatch and
iPay).

21. The reason this made sense is because premium
levels were juiced…and it felt like investors were
overly euphoric. Think about it? Did you really
think that everyone would agree on how much
value these products would bring to the stock in
one single day?

22. Of course not, the bulls and bears fought all
day…ultimately resulting in the stock price
barely changing from the previous day.

23. However, all that hopium was sucked out of that
option premium… and that strangle I discussed
on Twitter was closed out for a nice profit. Not
only that, but there wasn’t much pain
involved…an in and out job.

24. Who would have thought there would be
another opportunity just like that one, a week
later.

25. This time, the hype was surrounded around
Yahoo (YHOO), due to their 20% plus stake in
Alibaba (BABA).
On Friday, September 18th, Alibaba would
become the largest IPO in history.

26. There was so much buzz around this IPO… it was
ridiculous. Everyone was trying to gauge at what
price BABA would open up at…how it would
perform, was it going to do a Facebook like IPO
or fly to the moon?

27. The talking heads on TV were all praising this
mysterious Chinese company. The TV was
flooded with interviews of their charismatic
chairman, Jack Ma, whose rags to riches story is
something out of a Hollywood movie.

28. With BABA having no listed options on opening
day…the focus was on YHOO. On September
16th, 2014, I posted this on twitter:

30. With the stock trading around $42.70 , The
October $37/$48 was priced at $1.60.
(In a minute, I’ll break down the trade in full
detail…but before that, let’s try to understand
what the hoopla was all about…and why it was
probably just all noise)

31. Some speculators were assuming that if BABA’s
price had a massive move higher…it would
mean that YHOO’s stock price would end up
moving much higher as well.
However, other’s felt BABA was already priced
in…after all, YHOO’s stock price increased over
10% the 30 days leading up to the IPO.

32. We had two camps, one which thought that
YHOO would trade in the high 40s- low 50s if
BABA exploded…the other, feeling that it was
already priced and the stock was more
vulnerable to the downside.

33. There were tax implications involved in YHOO’s
stake in BABA…in addition, if BABA performed
strongly, those who had BABA stock pre-IPO
might be hedging by their position by shorting
YHOO because their BABA shares were locked
up.

34. These were very important considerations…
seemed like they both had high
expectations…but no clear sentiment on where
the stock price might go.

35. Similar to Apple’s product announcement….it
would take days to weeks to fully digest the
implications of the event. However, all this
confusion and uncertainty creates an
opportunity to sell rich option premium.

36. One thing we knew, was implied volatility was
going to come down during the IPO and through
the end of the day on Friday.

37. Breaking Down The Trade In Full Detail

38. Event: Alibaba IPO, investors believe Yahoo’s
stake in BABA is going to have a big impact on
Yahoo’s stock price that day.
Sentiment: There were two sets of opinions,
both presenting compelling cases. However, the
uncertainty and the ability to not come to a
conclusion (in a short period) creates a big
opportunity.

39. Trade Bias: Non-directional. Basically this means
I don’t care if the stocks moves higher or
lower…I just want the stock to move less than
what the market is implying it will.
The Trade: Selling the October 2014, $37 put
and $48 call strangle for a premium of a $1.60

40. YHOO 1 standard deviation strangle at market close on September 16, 2014

41. Yahoo (YHOO) stock price was trading around
$42.70

42. Implied Volatility:
YHOO average option implied volatility by each contract month September 16, 2014

43. YHOO daily price chart with average implied volatility plotted

44. (Notice how elevated the implied volatility in
Yahoo is. It’s very elevated compared to the last
52 weeks. Also notice how it experiences cycles)

45. The Idea: It will take days to weeks to figure out
what the BABA IPO means to YHOO…however,
implied volatility should come down, as the
uncertainty of how BABA’s stock price will
perform will be resolved once it starts trading.

46. Risk: “Theoretically undefined.” However, we
have to put this into perspective. YHOO is a $40
billion market cap company, the chances of it
getting bought out overnight is extremely slim
considering the circumstances.

47. Everyone is waiting for the BABA IPO, the
likelihood of YHOO gapping up or down,
overnight or in the pre-market again is very slim.

48. The biggest risk when shorting premium naked
is overnight or pre-market gap risk.

49. For a stock like AVNR, this overnight risk is very
real. However, when you’ve got premiums juiced
in high market cap companies that have a lot of
liquidity (in both stocks and options)…the risk is
worth exploring…especially when we’re talking
about a binary event that is likely going to take
some time to figure out it’s impact.

50. But Josh, doesn’t Tesla Motors fit in this
category? Does it make sense to short naked
premium in the stock if volatility is high?

51. First, Tesla is trading nearly $260 a share…that’s
a very expensive stock that will require a lot of
margin. Second, 23% of the shares floating in
the stock are short. That means investors are
borrowing the stock to sell it…in some cases
they actually have to pay for the borrow.

52. With that said, on very positive news, the stock
has the potential to really “squeeze” higher.
What happens is those who borrowed the stock
to short will have to cover by buying the stock to
close out of their position…in addition, there is
also buying pressure from those who want to
get long the stock.

53. Selling naked calls in a stock that has a high
short interest does create more risk…and you
should be aware of that.

54. In the case of stocks like Tesla, you’ll want to do
structured spreads to take advantage of high
option volatility situations.
Now, Yahoo only had 3% of the shares floating
short. The threat of a “short squeeze” wasn’t
there. Also, with the stock trading under $45 a
share, there wasn’t a lot of margin demand for
selling the strangle.

55. With little overnight and pre-market gap
risk…we’d be able to manage the position during
the trading day with no problems.

56. Break-Even: This was a non-directional trade,
having no opinion on where the stock will go.
The break-even at expiration is:
$48 + $1.60 = $49.60 upside
$37 – $1.60= $35.40 downside

57. Ok, if the stock is trading at around $42.70, that
gives us a range of 16% towards the upside to -
17%. A lot of magic would need to happen for
me to start feeling some pain. And at expiration
I’d be profitable anywhere from $35.40 to
$49.60.

58. That’s a very solid cushion given the stock and
the circumstances…

59. I probably will have plenty of time to make
adjustments if things were to get out of hand.

60. But here’s the thing, this is a binary event trade
with no intentions of staying till expiration …and
trying to collect the full premium. The play is to
buy back the options after the volatility
collapses… at sometime during the BABA IPO.

61. Note: If you’re using a risk analyzer for these
type of trades…do a what-if analysis on different
changes in implied volatility to get an idea of
what your position will look like.

62. For example, if implied volatility on your options
is 80% …how much would they be worth the
next day if implied volatility was lower, say 60%?
This is done to get an idea, we won’t know for
sure what the actual drop will be.

63. A lot of times, an event is overhyped…traders
who bought calls and put options expecting a
major move…become disappointed…and start
hitting the sell button trying to salvage whatever
premium they have left…which causes option
volatility to drop.

64. The reason I chose October strangles vs. the
weekly strangles is because I wanted to be short
more “vega” or option volatility. By shorting
near term options, I would have been short less
“vega” …but have greater directional risk in the
form of “gamma”…gamma refers to the option
greek that tells us how much the delta will
change.

65. By going out a little further in time, your trade
focus is more on the moves in implied volatility
(vega) vs. short term volatility (gamma).

66. Well, the day of the IPO, it almost seemed like
the entire market was on pause, waiting for
Alibaba to start trading. The underwriters had
priced the stock at around $68 or so…but
everyone knew that it was going to open up
around $90 per share.

67. It eventually opened around noon Eastern time,
in the $90s….went vertical touching nearly $100
per share…sold back down to the $90s…and was
pretty much in cruise control the rest of the
day…closing at $93.89 per share.

68. Folks, this is a company that has a market cap
larger than Amazon.com …how much volatility
were you expecting?

69. To the surprise of the bulls, Yahoo started to sell
off….possibly for some of the reasons
mentioned earlier in this article. Intraday, the
stock experienced a decent amount of volatility,
hitting a high of $42.40 and a low of $39.55.

70. However, leading up to the event there was too
much euphoria and the stock eventually settled
in and closed down 2.76% from the previous
day.

71. Option volatility collapsed, as the 30-day atm
implied volatility changed -15% from the
previous day.

72. YHOO average implied volatility by each month September 19, 2014

73. That strangle mentioned on twitter worked like
expected and closed out for a nice profit that
day.
YHOO 1 standard deviation strangle closing price
on September 19, 2014

75. This is really one of those textbook plays on how
to short volatility into an event that is most
likely going to be a non-event.

76. What You Can Take From This Article:

77. • Shorting naked options is not suitable for
every stock. Low market cap stocks are
vulnerable to being taken over through an
M&A. In addition, stocks with high short
interest have the potential to have an
extraordinary move (short squeeze).

78. • Find opportunities in stock options that offer
great liquidity, competitive bid/ask
spreads…where you feel option volatility is
elevated because of market euphoria….unlike
a biotech/pharma stock where high volatility
levels are justified.

79. • Trading options on high cap stocks makes
sense…it will take a lot of unanticipated news
to really move the stock. Yahoo circumstances
fit this really well.
• By going out to 30 days you are able to sell
more of that option volatility (vega)

80. • The focus was to get out of the trade during
the day of the IPO…with the idea that it would
take a couple days to weeks to fully grasp
what this meant to Yahoo…while the implied
volatility gets sucked out of the premium.

81. • Low priced stocks like Yahoo have smaller
margin concerns. However, you should still
size your trades accordingly so there is some
margin for error.

82. By the way, did any trade it similar to this trade?
To be honest, this seemed like a layup…
unfortunately, options investing is not always
this easy. Often times, you’ll be tested when
you’re short premium and be forced to take
some form of action.

83. However, it’s important to find situations where
the market has to beat you in order for you to
lose money vs. getting caught up in the euphoria
and chasing…like we recently saw in Apple and
Yahoo.

84. Do you think you’ll be able to spot the next
opportunity like this if you see it? I’d love to
hear from you… I’ll be hanging out in the
comments section below.

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