Volatility: Don’t Make These 3 Options Trading Mistakes

If you’re an option trader, you should know that every trade you make is also a bet on volatility. If you’re long a call or a put — you’re also long volatility. If you’re short a put, a credit spread, or an iron condor, you’re also short volatility. That means that having a directional opinion on volatility can help add some extra juice to your trades that wouldn’t be there otherwise. Likewise, it can help you avoid making simple mistakes that could turn out to be costly.

Here are a few examples of how volatility could make or break your trade — even if you’re directionally right.

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Buying LEAPS When Volatility is High

LEAPS are long-term equity anticipation securities — AKA options that expire more than a year from now.

Imagine this scenario: the stock market is trading down. Volatility is high. You’re thinking about “buying the dip”, and you want to give yourself plenty of time. So you buy a few out-of-the-money LEAPS! “A fool-proof plan”, you think to yourself. “This stock will surely rise between now and the expiration, giving me plenty of time to see profit!” But it isn’t a fool-proof plan, because you forgot to account for one thing:

Volatility. 

Recall that long calls and puts are also long volatility. And if you bought these long-dated call options when volatility was high, you may end up watching the underlying stock go up while the value of your option goes down. 

How could this be?! 

It’s because of an option greek called Vega, and a factor called extrinsic value. 

Vocab Check:

• Option Greeks: Measures the sensitivity of an option’s price to the underlying asset. Option Greeks come together to help determine the price, or premium of an option contract.
• Vega: The option greek that measures an option contract’s sensitivity to volatility in the underlying asset. 
• Intrinsic Value: The “true value” of an option contract. Think of the intrinsic value as a matter of “what would the option be worth if it expired right now?” By nature, out-of-the-money options have zero intrinsic value, because if they expired right now, they would be OTM! 
• Extrinsic Value: The difference between the price, or premium of an option, and the intrinsic value. Extrinsic value accounts for what could happen between right now and the options expiration, factoring in values like time-decay and volatility. 

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When volatility in an asset is high, so is Vega. When Vega is high, an option contract is going to “price-in” more extrinsic value. That means when you purchase a long option with high Vega, you’re paying extra for the possibility of volatile price swings in the future.

So to go back to our example of a trader who bought LEAPS during a period of high volatility, the mistake that they made should now be clear. They bought a contract that was pricing in high volatility. When the volatility declined, the Vega decreased, and so did the extrinsic value of their option. 

How to avoid this mistake and put volatility in your favor with call LEAPS: If you’re entering call LEAPS, you should have a bullish opinion on the underlying stock and a bullish opinion on that stock’s volatility. Preferably, volatility should be low when entering the trade, allowing you to get in without paying for a lot of extrinsic value. In order to negate some of this extrinsic value risk, traders may find it useful to use in-the-money options with a high ratio of intrinsic-to-extrinsic value, rather than out-of-the-money options with zero extrinsic value.

Here’s an example of a costly mistake on the opposite end of the spectrum that you’ll want to avoid.

Selling Cash-Secured Puts When Volatility is Low

The premise of a cash-secured put is to collect a premium by selling an option in exchange for a promise to buy 100 shares of the underlying stock if, by expiration, the stock is below that price. A trader may enter a cash-secured put in order to get into a stock at a price point that they like, or they may just use it to sell options on a stock they wouldn’t mind owning at some point in the future.

Cash-secured puts are a popular way to sell options with defined-risk. That means there’s no possibility of “infinite loss”. For example, imagine that a stock is trading at $25 per share, and you sell a $15-strike put. In this case, the max amount of money you can lose is $1,500 subtracted from the amount of option premium you collect in the trade. Whatever amount of money that is, your brokerage will typically withhold it as collateral until the option expires or you close the trade early — and often, traders do close the trade early.

Imagine this scenario: You sell an out-of-the-money cash-secured put. You could buy 100 shares of the stock if you had to, but if at all possible, you’d like that put option to stay out-of-the-money. “A few days before expiration, after theta has taken its toll, I’ll close the put,” you think to yourself. 

Enter: volatility. 

Recall that short options are also short volatility. That means that even if the short option is still out-of-the-money, if the price of the stock is barreling towards your short strike, you may be in for an unwelcome surprise: volatility swell. As the Vega increases in your short-put, the options market begins to price-in the possibility that volatility could drag the underlying stock below that strike price — expanding the extrinsic value. Now, even though there is still time left on the trade, and the put isn’t yet in-the-money, your original plan to “close out the option near the expiration” is in danger. Faced with an option that now costs more than when you originally sold it, you’re faced with an unpleasant choice: 

• Close the option, and take a loss. 
• Hold the option closer to expiration, and potentially be forced to buy 100 shares of the underlying stock — possibly for more than they’re worth.

How to avoid this mistake and put volatility in your favor when selling cash-secured puts: Because short puts are also short volatility, you should be bullish on the stock, and bearish on volatility. Preferably, volatility should be high when you enter this type of option trade, giving you enough premium to make the reward worth the risk. For example, if the option is already nearly worthless, with very little extrinsic value priced-in, and you’re risking a high amount of collateral to make the trade — it might not be worth it. Especially if volatility rolls in and amplifies the extrinsic value of the option after you enter the trade. 

Want more free market intel? Check out Market Rebellion’s Rebel Hub for the biggest stories on market-moving events, how-to trading guides, and the latest in Unusual Option Activity from Jon and Pete Najarian.

Here’s one more instance where volatility may come back to bite you, even if you’re directionally right:

Holding Options Through Earnings Events

Earnings events are quarterly data releases that often lead to big moves in the underlying stock. Because of this propensity for making large moves, these events are popular among traders. However, option traders looking for big returns on earnings should beware of this big factor: volatility crush.

Imagine this scenario: You know a stock that’s going to report earnings tonight. It’s trading at $90, and you think it could move above $100. So you buy the weekly-expiring $100-strike call options. That night, the earnings report is released, and the shares move higher. You rejoice — you were directionally correct on the stock’s movement! But when you wake up in the morning, your option has lost value. 

Why did this happen? Because the options market was pricing-in a bigger move than took place! You had a call, the stock price went up, but volatility declined and the overall value of your contract is now less than what you bought it for. 

Going into earnings, implied volatility and extrinsic value are going to be higher than usual. And following earnings, that IV will most likely decrease. That means that when holding options through earnings, you need an extra-large move in the underlying stock in order to make up for the volatility crush. That isn’t to say it’s impossible to succeed when holding an option through an earnings event, but it’s an extra factor to be highly cautious of, and it’s a common mistake that new option traders make.

Volatility Can Get in the Way, or it Can Give Your Trade an Edge

Volatility is an important factor to consider when trading options; but it isn’t the end-all be-all of your trade. You may be wrong about volatility, but right about other aspects. Meaning, you aren’t necessarily at a disadvantage every time you go long an option during high volatility. For example, you may find that volatility continues to increase — working in your favor to amplify the extrinsic value, and subsequently the premium of the option. You may also find that even if volatility decreases after the purchase of your option, the move in the underlying stock is large enough to offset the loss of volatility. 

Still, being vigilant on volatility can give your trade an ‘extra edge’, and being directionally right about volatility can help cushion the blow associated with being directionally wrong on an asset’s price. That’s why skilled option traders always consider volatility whenever they make a trade.