Good volatility, bad volatility

Most investors and traders need volatility, whether they know it or not. For example, if you bought a stock and its price didn’t change for 10 years, you may be a tad disappointed.

It’s just that most people want a certain type of volatility—namely, the type that increases the bottom line rather than eating into it. Volatility is simply price movement. We love it (or ignore it) when it’s in our favor, and hate it when it’s not. But for options traders, even sharp downside volatility can sometimes have its advantages, if you know how to harness them.

For example, on Wednesday the implied volatility (IV) in SBA Communications (SBAC) was at a 52-week high:

That means the options market was expecting SBAC’s volatility (over the next 30 days) to be as high as it has been at any point over the past year.

Although there’s no way to know whether the options market’s forecast will be correct, SBAC’s price chart shows why traders would be thinking that way. In addition to several big price swings this year, last week the stock retreated to the support level defined by its February and June lows:

The stock definitively broke down below that level yesterday with its biggest down day in nearly three months. SBAC appeared on the same high-IV scan intermittently throughout the day.

The key point for options traders to remember in this type of situation is the effect that high IV has on options prices. All else being equal, it makes them more expensive, since in uncertain (volatile) conditions, options sellers will demand higher premiums for assuming the risk of potentially open-ended losses.

That, in turn, suggests options buyers need to be cautious about overpaying for options that may lose a signficant portion of their value—even if the stock moves in their direction—if IV cools down. Options sellers, on the other hand, may be better positioned to “sell high and buy low,” except that they are selling volatility instead of price.

For example, a trader who thought a move like the one in SBAC could be a “bear trap” (a downside breakout draws in sellers but soon reverses to the upside) may consider going long. In options, the most straightforward way to do that would be to buy calls or sell puts. But because all options may be overpriced because of high IV, some traders may decide selling puts provides more of an edge than buying calls.

Finally, the high-IV problem can also be at least partially addressed by using a spread that combines long and short options. For example, a trader with a bullish outlook on a high-IV stock may use a vertical call spread, which typically pairs a long at-the-money call option with a short, higher-strike call. The short option is short volatility and time—thus offsetting some of the long call’s negative exposure to these factors.

So, instead of thinking of volatility as good or bad, traders may be better served by trying, whenever possible, to swim with the volatility tide instead of against it.

Market Mover Update: The crude oil rally that unfolded around OPEC’s recent decision to cut oil production lost a little momentum yesterday. November WTI crude oil futures (CLX2) pushed higher on Thursday, extending the rally over the past eight trading days to more than 15%, but it was the market’s smallest daily gain of all its up days since September 26:

Yesterday’s intraday rally stalled out at $89.07, just a little below the short-term resistance level implied by the market’s September high.

Today’s numbers include (all times ET): Employment Report (8:30 a.m.), Preliminary Wholesale Inventories (10 a.m.).

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