Sharpening the volatility edge

Traders who understand that high implied volatility (IV) can, all else being equal, make options more expensive while low IV can make them cheaper, may scan for symbols with low or declining IV if they’re interested in buying options.

It’s a logical premise, but it comes with some caveats. Yesterday’s LiveAction scan for biggest one-week IV declines included stocks whose IV dropped anywhere from roughly 76% to 30% (the symbols are sorted here by their stock prices):

Good hunting ground for low-IV—and potentially underpriced—options? Perhaps, but not always. Many of these stocks—including United Parcel Service (UPS) and IBM (IBM)—had something in common: They recently released earnings, and one of the hallmarks of earnings season is the volatility crescendo that typically occurs before a company reports numbers. Even if a stock doesn’t move much in the runup to earnings, its IV often will—a reflection of uncertainty about the outcome. After the announcement, IV usually falls, since that uncertainty has been removed.

One of the most important things to keep in mind about this tendency is that while IV often falls sharply after earnings, it doesn’t necessarily do so all at once, and because it is often falling from a very high (pre-earnings) level, it may not be as low as some traders think. And that can mean options aren’t as inexpensive as they think.

First, take a look at UPS, which released earnings before the bell on Tuesday. The bottom of the chart compares its 30-day IV with its 30-day historical volatility (HV), which simply reflects how much the stock has moved over the past 30 days (both volatility lines reflect performance through Tuesday):

While UPS’ IV may have dropped yesterday, the chart shows it was still well above HV on Tuesday, and very close to its highest levels of the past several months. That could mean UPS options may have still been relatively pricey, despite Wednesday’s big IV drop.

Now consider IBM, which released earnings after the bell on October 19, and rallied more than 10% over the next five trading days. In this case, though, the bottom of the chart shows its IV was already below its HV before Wednesday’s big IV drop:

Whether that’s a factor of more time having passed since expiration or the stock’s strong post-earnings rally (or both), IBM IV appeared to be lower—on a relative basis—than UPS IV yesterday. That means, of these two stocks, IBM may have been a better candidate for long options positions.

Experienced options traders know that buying low-IV options and selling high-IV options can help make volatility an ally rather than an enemy. But they also know that “high” and “low” are relative, and it can take a little work to know whether options are potentially underpriced or overpriced.

Market Mover Update: Open interest in Steel Dynamics’ (STLD) December $80 calls dropped from 2,800 on Tuesday to less than 700 on Wednesday, which means the majority of Tuesday’s heavy volume consisted of traders getting out of their positions. But the stock also rallied more than 2.5% intraday and hit a new all-time high (see “Bearish call trading?”).

Today’s numbers include (all times ET): Durable Goods Orders (8:30 a.m.), GDP (8:30 a.m.), Weekly Jobless Claims (8:30 a.m.), EIA Natural Gas Report (10:30 a.m.), Kansas City Fed Manufacturing Index (11 a.m.).

Today’s earnings include: Baxter (BAX), Southwest Airlines (LUV), American Tower (AMT), Merck (MRK), Amazon.com (AMZN), Apple (AAPL), Intel (INTC), McDonald's (MCD), Keurig Dr. Pepper (KDP), First Solar (FSLR), Verisign (VRSN), Shopify (SHOP), Mastercard (MA), Honeywell (HON), US Steel (X).

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