●High/low implied volatility (IV) associated with overpriced/underpriced options.
●Some traders prefer to sell high-IV options and buy low-IV options.
●FL and DSW options illustrate recent high-IV and low-IV conditions.
Two shoe stocks, two earnings releases, two types of potential trade setups—all in one day.
Having a handle on implied volatility (IV)—the market’s estimate of future volatility embedded in the price of an option—is a key part of figuring out whether an option may be relatively over- or undervalued. As a general rule, traders often look for options with exceptionally low IV as potential buy candidates and those with high IV as potential short candidates, since the higher the IV, the higher the options price (all else being equal).
Take a look at the chart (above) of implied volatility for Foot Locker (FL), which shows IV for the September options was much lower than its 30-day average. If other trade considerations align (for example, expected stock price action, the amount of time until expiration), a trader may decide to buy FL options, since they may be relatively underpriced.
Now let’s try on another shoe—in this case, DSW (DSW), aka Designer Shoe Warehouse. The chart below shows that yesterday the IV for DSW September options was much higher than its 30-day average—a possible sign of overpriced options and potential shorting opportunities.
There happened to be a good reason for these stocks’ respective IV levels. Implied volatility often climbs just prior to earnings announcements, as investors attempt to protect their stock holdings with options and traders position themselves to take advantage of the expected price action. Just as predictably, IV often drops significantly after earnings announcements.
Foot Locker released earnings last Friday, beating its headline numbers but disappointing some investors with smaller-than-expected sales growth.1 The stock pulled back sharply (chart below), but as of yesterday had held that initial low.
An options trader who expected the stock to rebound in the near term may buy FL September call options because their low IV may make them a relative bargain. (The fact that the stock was also much lower than it was a few days earlier would also contribute to cheaper call prices.) Of course, a trader expecting continued downside could buy put options.
DSW presented the opposite situation—an explosive up move (25% intraday) after it crushed its earnings numbers yesterday (chart below). Given the relatively high level of IV (although it may be different today), some traders may consider shorting DSW September options. Although longer-term DSW bulls may short put options in anticipation of further gains in the stock (or at least sideways price action), traders who expected the stock to retrace at least some of its massive jump could look to short calls, especially since DSW’s huge up move inflated call options prices and deflated put options prices.
For example, when the stock was trading around $32.50 yesterday, the September $30 call option was trading around $2.90, which was around 84% higher than the day before. By contrast, the September $35 put option—which was the in the money by the same amount as the $30 call—was trading 60% lower than it was a day earlier.
Just like in the shoe store, with options you have…options. And it helps to know which ones fit the occasion.
1 BusinessInsider. Foot Locker beats on the top and bottom lines, but same-store sales whiff (FL). 8/24/18.
2 MarketWatch. DSW Inc. shares soar 18% premarket after earnings blow past estimates. 8/28/18.