Buying and selling volatility

03/15/22
  • Large options trades in TPR suggest possible “strangle”
  • Stock recently broke below bottom of long-term range
  • Volatility high as shares bounced off 13-month low

Just as long, steady price trends can lull investors and traders into complacency, high volatility can trigger a defensive “when will the pain end?” mindset. When prices drop sharply or lurch up and down on a daily basis, even a one-week price trend can feel like a distant memory.

More importantly, this condition can have a tangible effect on options prices.

Experienced options traders understand that volatility tends to cycle between highs and lows, and factor that tendency into their decision-making. In short, they try to avoid buying options that may be overpriced because of high volatility. Instead, they often look to sell potentially high-priced options in high-volatility environments—sometimes without any opinion about the direction of the underlying stock.

Options activity on Monday morning helps illustrate why. Not only did luxury goods retailer Tapestry (TPR) have unusually high options volume on Monday morning (about 14 times average), the majority of that volume was evenly divided into two 6,600-contracts positions, one in the May $27.50 puts and the other in the May $40 calls:

Chart 1: Tapestry (TPR) May options, 3/14/22. Tapestry (TPR) options chain. Possible options strangle?

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Since the stock was trading around $34 early at the time, that means both options were out of the money (OTM): The puts were below the current stock price while the calls were above it.

The combination of OTM calls and puts is the basis for the strangle position. Traders who buy the options to create a long strangle are essentially taking a “long volatility” position, since the stock needs to move enough above the call’s strike price or below the put’s strike price to cover the cost of buying both options. In other words, increasing volatility helps the position.

But traders who sell both options to create a short strangle are, in effect, selling volatility (and time)—and that means they want volatility to decrease, not increase. The less the stock moves, the better the chance it will remain between the two strike prices—in which case, both options would ultimately expire worthless and the trader would keep all the premium collected from selling them:

Chart 2: Short strangle risk-reward profile. Can profit from falling volatility, steady prices.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Even if we assume that yesterday’s large options trades in TPR represented a big strangle—and that’s a big assumption—we have to remember that every option buyer has a seller. But let’s walk through the logic of a possible strangle seller in light of yesterday’s market conditions.

Selling volatility is no different than selling stock—in both cases you want to sell as high as possible. Option traders aware of the effect of implied volatility (IV) on options prices may have factored in that TPR’s volatility had recently jumped to its highest levels in more than a year (chart bottom):

Chart 3: Short strangle risk-reward profile. Can profit from falling volatility, steady prices.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


The volatility surge occurred as the stock fell to its lowest price since February 2021. Although options IV was less than the stock’s historical volatility (HV), both measures were at near their highest levels since last March. All else being equal, premiums were more likely to have been inflated by higher-than-average volatility than deflated by lower-than-average volatility.

The stock broke amid the Russian invasion of Ukraine—an event that has also helped send the broad market to its lowest levels in nearly a year. While that unexpected shock has, understandably, elevated volatility across the markets, it’s also understandable that a trader would interpret the breakdown in a stock like TPR to be an aberration from its longer-term trend, and expect volatility to cycle back to more moderate levels.

And when a trader expects a stock to trade with a confined range and options volatility to drop toward its long-term average, a short strangle can make sense.

Market Mover Update: On the doorstep of what’s expected to be the Fed’s first rate hike in more than three years, financials stocks led the market on Monday, with the S&P financial sector gaining more than 2% while the S&P 500 lost ground for the day. Financial stocks, many of which are in the business of lending money, can benefit from a rising-rate environment.

Today’s numbers include (all times ET): Producer Price Index, PPI (8:30 a.m.), Empire State Manufacturing Index (8:30 a.m.), FOMC meeting starts.

Today’s earnings include: ANI Pharmaceuticals (ANIP), Dole (DOLE).

 

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What to read next...

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