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How To Successfully Use Option Volatility To
Trade Binary Events

by Joshua Belanger
Contrary to popular investing belief and outdated content, volatility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 practiceand 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
warrantedbut many times its not.
For example, I know that drug stocks tend to have very high implied
volatility levelshowever, I also know that they can move a lot (in
either direction)making it hard to justify ever shorting premium in
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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.
Sounds pretty overzealous right?
Well, the following Monday, AVNR announced positive Phase II trial
results on their Alzheimers disease drug. The stock traded over $13
per shareup over 90% ! And get thisoption volatility spiked from
99.19% to 128.2%
By the way, detecting this kind of options activity is covered for you
in full detail in The SIZZLE Method Report. Its your nuts and bolts
guide teaching you my process how to use unusual options activity
to generate winning trading ideas.
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 rewardsort of like gambling and not
suitable for most option investors.
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.
In many of these cases, their options arent 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.
Shorting naked premium without a justifiable reason can be a very
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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.
One reply to How To Profit From Option Volatility was this from,
@zzbar on twitter:

I get itsometimes you enter a position and it goes horribly
wrongyou get frustrated, upset and wish you never got involved
with it in the first place. Believe me, its happened to me before and
Im sure to a whole lot of other folks.
However, theres ways to reduce the impact of these type of
lossesby respecting the power of leverage and sizing your
positions accordingly.
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.
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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.
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).
The reason this made sense is because premium levels were
juicedand 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?
Of course not, the bulls and bears fought all dayultimately
resulting in the stock price barely changing from the previous day.
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 wasnt much pain involvedan in and
out job.
Who would have thought there would be another opportunity
just like that one, a week later.
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.
There was so much buzz around this IPO it was ridiculous.
Everyone was trying to gauge at what price BABA would open up
athow it would perform, was it going to do a Facebook like IPO or
fly to the moon?
The talking heads on TV were all praising this mysterious Chinese
company. The TV was flooded with interviews of their charismatic
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chairman, Jack Ma, whose rags to riches story is something out of a
Hollywood movie.
With BABA having no listed options on opening daythe focus was
on YHOO. On September 16th, 2014, I posted this on twitter:

With the stock trading around $42.70, The October $37/$48 was
priced at $1.60.
(In a minute, Ill break down the trade in full detailbut before that,
lets try to understand what the hoopla was all aboutand why it
was probably just all noise)
Some speculators were assuming that if BABAs price had a massive
move higherit would mean that YHOOs stock price would end up
moving much higher as well.
However, others felt BABA was already priced inafter all, YHOOs
stock price increased over 10% the 30 days leading up to the IPO.
We had two camps, one which thought that YHOO would trade in the
high 40s- low 50s if BABA explodedthe other, feeling that it was
already priced and the stock was more vulnerable to the downside.
There were tax implications involved in YHOOs stake in BABAin
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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.
These were very important considerations seemed like they both
had high expectationsbut no clear sentiment on where the stock
price might go.
Similar to Apples 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.
One thing we knew, was implied volatility was going to come down
during the IPO and through the end of the day on Friday.
Breaking Down The Trade In Full Detail
Event: Alibaba IPO, investors believe Yahoos stake in BABA is going
to have a big impact on Yahoos 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.
Trade Bias: Non-directional. Basically this means I dont care if the
stocks moves higher or lowerI 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

YHOO 1 standard deviation strangle at market close on September 16, 2014
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Yahoo (YHOO) stock price was trading around $42.70
Implied Volatility:

YHOO average option implied volatility by each contract month September 16,
2014
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YHOO daily price chart with average implied volatility plotted
(Notice how elevated the implied volatility in Yahoo is. Its very
elevated compared to the last 52 weeks. Also notice how it
experiences cycles)
The Idea: It will take days to weeks to figure out what the BABA IPO
means to YHOOhowever, implied volatility should come down, as
the uncertainty of how BABAs stock price will perform will be
resolved once it starts trading.
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.
Everyone is waiting for the BABA IPO, the likelihood of YHOO
gapping up or down, overnight or in the pre-market again is very
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slim.
The biggest risk when shorting premium naked is overnight or
pre-market gap risk.
For a stock like AVNR, this overnight risk is very real. However,
when youve got premiums juiced in high market cap companies
that have a lot of liquidity (in both stocks and options)the risk is
worth exploringespecially when were talking about a binary event
that is likely going to take some time to figure out its impact.
But Josh, doesnt Tesla Motors fit in this category? Does it make sense
to short naked premium in the stock if volatility is high?
First, Tesla is trading nearly $260 a sharethats 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 itin some cases they actually have to pay for the
borrow.
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 positionin addition, there is also buying pressure from those
who want to get long the stock.
Selling naked calls in a stock that has a high short interest does
create more riskand you should be aware of that.
In the case of stocks like Tesla, youll 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 wasnt there. Also, with the stock trading under $45
a share, there wasnt a lot of margin demand for selling the strangle.
With little overnight and pre-market gap riskwed be able to
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manage the position during the trading day with no problems.
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
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 Id be
profitable anywhere from $35.40 to $49.60.
Thats a very solid cushion given the stock and the
circumstances
I probably will have plenty of time to make adjustments if things
were to get out of hand.
But heres 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.
Note: If youre using a risk analyzer for these type of tradesdo a
what-if analysis on different changes in implied volatility to get an
idea of what your position will look like.
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 wont know for sure
what the actual drop will be.
A lot of times, an event is overhypedtraders who bought calls and
put options expecting a major movebecome disappointedand
start hitting the sell button trying to salvage whatever premium they
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have leftwhich causes option volatility to drop.
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 gammagamma
refers to the option greek that tells us how much the delta will
change.
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).
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 sobut everyone knew that it was
going to open up around $90 per share.
It eventually opened around noon Eastern time, in the $90s.went
vertical touching nearly $100 per sharesold back down to the
$90sand was pretty much in cruise control the rest of the
dayclosing at $93.89 per share.
Folks, this is a company that has a market cap larger than
Amazon.com how much volatility were you expecting?
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.
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.
Option volatility collapsed, as the 30-day atm implied volatility
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changed -15% from the previous day.

YHOO average implied volatility by each month September 19, 2014
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
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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.
What You Can Take From This Article:
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).
Find opportunities in stock options that offer great liquidity,
competitive bid/ask spreadswhere you feel option volatility is
elevated because of market euphoria.unlike a
biotech/pharma stock where high volatility levels are justified.
Trading options on high cap stocks makes senseit 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)
The focus was to get out of the trade during the day of the
IPOwith the idea that it would take a couple days to weeks to
fully grasp what this meant to Yahoowhile the implied
volatility gets sucked out of the premium.
Low priced stocks like Yahoo have smaller margin concerns.
However, you should still size your trades accordingly so there
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is some margin for error.
By the way, did any trade it similar to this trade?
To be honest, this seemed like a layupunfortunately, options
investing is not always this easy. Often times, youll be tested when
youre short premium and be forced to take some form of action.
However, its 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 chasinglike we recently saw in Apple and Yahoo.
Do you think youll be able to spot the next opportunity like this if
you see it? Id love to hear from youIll be hanging out in the
comments section below.