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How to take Advantage of High Implied Volatility

Implied Volatility (IV) gets high when a company has some impending event that can move the stock price.  The impending event sometimes refers to the stock as being a special situation stock.  The impending event causes the option IV to change based on the likely stock price move.  Here are some causes that increase IV:
 

  • There is a pending event such as an earnings report, FDA ruling, etc.
  • A significant news event is pending on another company in the same industry
  • The company’s industry is more volatile due to expected changes
  • The stock has a higher level of volatility so its options are more expensive
  • An aberration occurs as there is no apparent reason for more expensive options.

When a stock is already moving its price, option premium will be high.  IV will simply reflect that volatility and potentially more volatility. Options are also more expensive when a stock is in a confirmed trend.  
 
Time value that is inflated due to spiking IV will collapse when the event causing the spike arrives.  You do not want to be long an option when IV collapse as you can lose money even if the stock price doesn’t fall.  In general, you want to buy low volatility and sell high volatility.

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To use high volatility to your advantage when you are Bullish:

  1. Buy stock as options are expensive;
  2. Write covered calls to collect higher premium;
  3. Sell naked or cash-covered puts for higher premiums;
  4. Write bull put spreads for higher credits.

If you are bearish with high volatility:

  1. Short the stock since puts are expensive;
  2. Sell naked calls;
  3. Write bear call spreads for credit.

How to Manage Risk with a Covered Call & Leap Strategy

When entering a covered write with a LEAP, the investor hopes that the short-term call written against the LEAPS will expire worthless.  The investor can then “roll” the short-term call to further-out months with the goal of collecting additional premium month after month.

There are three risks with covered call – LEAP strategy:

  • Stock price decline
  • Assignment (creates a short stock position)
  • Stock price rise can reduce profit

Managing actions should be planned in advance.

If the price falls too fast you have these options:

  1. Close position and realize the loss.
  2. Roll Down and Out by covering (buying back) short call and then selling lower strike call with later expiration date.
  3. Maintain position – hope for price rise.  Let short Call expire and keep LEAPS Call.

 

What if the short call is assigned when stock price rises above call strike price?  Here are some options:

  1. Close the whole position
  2. Buy stock (to cover): stay long LEAPS Call
  3. Buy stock (to cover) & sell another Short-term Call (now have a new LEAPS covered call).

If the stock price rises too much, your profits will be reduced.  Why are profits reduced if the stock price rises too much?

It’s called the “effective price” concept.  If a call is exercised, then stock is purchased.  The effective purchase price of the stock is the strike price plus the call premium.  For example:

Buy a 50 Call @ $3.00

If the call is exercised:

The total cost of the stock is $50 + $3 = $53

$53 is the effective price.

The following example shows how to calculate effective price:

Stock XYZ @ $53.80

Long 1 XYZ 18-month 45 Call @ $10.60

Short 1 XYZ 60-day 55 Call @ $1.25

Strike  +   Call Px  =   Eff Px

55 Call           55      +     1.25     =  56.25 Sell

LEAPS Call   45      +     10.60 = 55.60 Buy

Maximum Profit = +0.65

 Profit at expiration of short call can be higher if there is time premium in the LEAPS call.

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