Profit with Implied Volatility (Part III)

In the last installment of this implied volatility (IV) primer (http://www.optionfanatic.com/2012/04/01/profit-with-implied-volatility-part-ii/), I interpreted IV as the market’s prediction of how volatile the underlying market will be on an annual basis.  Shortening our time frame from one year to a day or two, IV is commonly used to predict earnings moves of stocks.

To understand this, let me first define straddle and strangle trades.  An at-the-money (ATM) straddle is the purchase of the nearest out-of-the-money put and call (different strike prices).  An ATM strangle is the purchase of the at-the-money put and call (same strike price).  For XYZ at $98.20/share, for example, an ATM straddle trade would require purchase of the XYZ 100 call and XYZ 95 put (assuming 5-point strikes in the option chain).  An ATM strangle trade would require purchase of the XYZ 100 call and XYZ 100 put.  Long (purchased) straddles and strangles generally profit from big market moves whereas short (sold) straddles and strangles profit by limited market moves.

The expected market move due to an earnings or other event is the average price of the front month (or weekly) ATM straddle and the front month (or weekly) ATM strangle.  Consider AAPL stock, which closed on January 24, 2012, at $420.41.  Earnings were due after market close.  The front month (weekly) was the weekly option, which had four days to expiration.  The ATM straddle and strangle were priced at $22.85  and $18.25, respectively.  The projected move was therefore the average:  $20.55 or 4.9%.

This information may be used in a couple different ways.  First, you may look back at historical stock moves after earnings to see where 4.9% fits in the range.  If the stock has never moved so little (much) in the last several years of earnings then you may consider the straddle/strangle to be underpriced (overpriced) and elect to buy (sell) it.  Second, you may look back at historical stock moves after earnings to see how often the stock moved more or less than the expected move.  If it’s about 50/50 then there may be no edge.  If the stock almost always moves more (less) than the expected move, however, then you may elect to buy (sell) a straddle or strangle on it.

In my next installment of this series I will describe another trade designed to profit from IV.