One of the advantages of an option based approach to trading is the ability to capitalize on trades that have a statistically well-defined high probability of profit. When events occur with predictable regularity, the knowledgeable option trader can effectively increase his odds of success.

One of the most reliable and reproducible events occurring in an option chain is the rise of implied volatility (IV) that occurs as the earnings release date approaches and its collapse immediately following earnings release. It is this run up in IV and its dramatic decrease once earnings have been announced that forms the basis for high probability option trades.

This pattern of ebb and flow is clearly shown on the chart presented below of chipmaker NVDA. Note that spikes in IV (the blue continuous line) occur precisely before earnings (blue triangles) and rapidly fall to significantly lower levels immediately after earnings.

Another observation from this chart is that the magnitude of the IV spike in anticipation of earnings release is not always the same. Since the peak may be variable in size from one earnings cycle to the next, not every earnings release may set up as high probability candidate for trading.

Another aspect important to recognize is the horizontal skew induced in the options chain; this skew is quite variable as regards different underlyings. Again with NVDA as our example, consider the options matrix below, a snapshot of the IV situation at market close on Thursday August 11 in anticipation of earnings release to follow the closing bell (OptionVue labels IV as MIV).

NVDA before earnings release

Consider then the second matrix showing volality 24 hours later after earnings have been released. Note the dramatic reduction in the IV of the longer dated options. OptionVue does not calculate IV on options expiring in less than 24 hours, but the fact that both the put and call are trading within pennies of intrinsic value indicates a very low IV as well as the short amount of time remaining in the option’s life.

NVDA after earnings release

A couple of take home messages are important here:

- IV rise and collapse is most extreme in the first option series expiring following earnings release.
- IV rise and collapse not only effects the front series but affects other expirations as well, albeit to a lesser but variable degree.

As Joanna White’s excellent blog post of March 5 this year discussed, these large changes in IV have a huge impact on the price of an option. Certain earnings strategies suggested by some writers, for example buying a calendar spread, can be severely negatively affected by this decrease in IV in the option in which you hold a long position.

The most important factor to consider when selecting candidates for earnings trades is an understanding of current levels of the IV in relation to the historic range for that specific underlying. Remember that each underlying has its characteristic range of IV. The changes occur in a heartbeat following earnings release, and there is no time to react to resurrect the trade.

In upcoming articles on this topic I will discuss an approach to gathering necessary data and designing a high probability trade to take advantage of this stereotypic sequence of events. However, do not think for a moment that is “free money”; it is a trading strategy with a high probability of profit but no guarantees.

]]>One measure of risk that is common for option traders is to use standard deviations of movement. I built a popular Standard deviation calculator to calculate the range of movement for a given set of numbers. It was accessed nearly 500 times in the past week!

An option trader can also use Delta to estimate the probability that an option will expire in the money. If you sell an iron condor, you would add up the absolute values of the deltas to give you the rough approximation of the probability of the entire trade expiring in the money.

Many of the Capital Discussions members trade the RUT as the underlying. Let's put a hypothetical trade on:

Symbol | Expiry | Action | Quantity | Strike | Type | Price | Delta |
---|---|---|---|---|---|---|---|

RUT | JUL5 | BUY | +10 | 1310 | CALLS | 2.28 | +9.46 |

RUT | JUL5 | SELL | -10 | 1290 | CALLS | 6.20 | +21.4 |

RUT | JUL5 | SELL | -10 | 1200 | PUTS | 11.15 | -20.5 |

RUT | JUL5 | BUY | +10 | 1180 | PUTS | 7.85 | -14.5 |

Here is a summary of the position:

Delta | Gamma | Theta | Vega | DTE | SV | ATM Call IV |
---|---|---|---|---|---|---|

-59.16 | -3.72 | 193.3 | -576.3 | 25 | 11.7% | 18.7% |

This is what it looks like in OptionVue software:

If you look at the full size image, you'll see on the left that OptionVue is estimating an 83% probability of profit at expiration. Pretty good right?

Statistical Volatility (SV) is backwards looking and shows you what the underlying actually did. Implied Volatility (IV) is normally what traders use to look forward to estimate their probabilities. A common IV is the Call at-the-money IV for the expiration you are trading in. In this case, that's a volatility of 18.7%, which is 7.0% higher than SV in our example. The market is anticipating higher volatility.

Notice the two standard deviation range expanded quite a bit. The price went from 1174.22 to 1131.95, or a 42.27 point further drop! Our probability of profit went from 83% to 61%. Ouch. Not quite as safe as we thought it was.

Volatility will increase. Let's look at the volatility chart to see how much it might go up:

It is reasonable to assume volatility could rise an addition 3% if the market sells off. Let's bump the volatility up to 21.7% and see how things look:

Things got even worse! Our probability of profit isn't 83% but is now at 54%. Our two standard deviation move lower boundary is at 1114.32, or 59.90 points lower that we initially thought it was.

When you are evaluating a trade during lower volatility, you can often find very comforting percentages, but if volatility rises, the numbers get worse very quickly. Be prepared for fast moving markets and plan on volatility rising. Don't assume the probability of profit will remain the same or improve as time passes. If you get a quick market move and volatility spikes, your beautiful risk chart can transform into an ugly chart very quickly.

Don't get lulled into a false sense of security. Plan on volatility rising and the standard deviation ranges expanding as volatility rises.

]]>As the instructions say, you just enter in the price of the underlying, the volatility and your position Greeks. The calculator does the math for you and color codes certain fields if you are ok or need to monitor them more closely.

]]>Here's a screen shot of it:

As the instructions say, you just enter in the price of the underlying, the volatility and your position Greeks. The calculator does the math for you and color codes certain fields if you are ok or need to monitor them more closely.

This tool is merely an aid to make you aware of when your option Greeks may be getting out of line. It is up to you to figure out if you need to wait or if you want to make an adjustment or not.

Be careful not to use the tool to over-adjust your trades. You need to give your trades some breathing room.

You can use this calculator for any option trade (such as Weirdors, Butterflies and Iron Condors) to get an idea if your option Greeks are skewed too much. The tool assumes you are trying to keep your delta's low and theta high, which is typical for non-directional option trades.

If you are a directional option trader, this tool likely won't help you as much.

Enjoy the tool.

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Jim sent me an interesting link to six figure investing's article on "Thirteen Things Your Should Know About Trading VIX Options." Bullet point number four says

"The option greeks for VIX options (e.g. Implied Volatility, Delta, Gamma) shown by most brokers are wrong (LIVEVOL and Fidelity are notable exceptions). Most options chains that brokers provide assume the VIX index is the underlying security for the options. In reality, the appropriate volatility future contract is the underlying. (e.g., for May options the May VIX futures are the underlying)."

]]>I posted in the forums about seting up OptionVue correctly to get the correct greeks for VIX options.

Jim sent me an interesting link to six figure investing's article on “Thirteen Things Your Should Know About Trading VIX Options.” Bullet point number four says

“The option greeks for VIX options (e.g. Implied Volatility, Delta, Gamma) shown by most brokers are wrong (LIVEVOL and Fidelity are notable exceptions). Most options chains that brokers provide assume the VIX index is the underlying security for the options. In reality, the appropriate volatility future contract is the underlying. (e.g., for May options the May VIX futures are the underlying).”

I've used OptionVue software since 2006 which made me wonder if OptionVue was using the underlying future to calculate the greeks so I asked Len Yates, the co-owner of OptionVue. Len said to load the VX futures contract as the underlying in the matrix and that will correctly calculate the VIX greeks.

If you aren't using OptionVue or LiveVol, be very careful of the greek values on VIX options.

I'm in the process of getting LiveVol X and will be able to update this article with data from ThinkOrSwim, OptionVue and LiveVol and compare the values for the same instruments.

Stay tuned for that (or sign up for our RSS feed or email updates to have it sent to you automatically)

Are you trading the VIX or any volatility products?

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