●Stock has been in wide trading range since June, despite two sharp sell-offs
●RHT options volatility dropped significantly from last week
●A short-options or long-options situation?
When Linux enterprise software and cloud computing firm Red Hat (RHT) tumbled 6.5% on September 20, it was the second quarter in a row that the stock gapped sharply lower after a disappointing earnings release. The following chart shows this month’s drop actually paled in comparison to the -14% hit the stock took after releasing its numbers on June 21:
What now? Let’s concede that regardless of the recent news and numbers, some traders at this point think the stock will rebound, some think it will go lower, and others think it will continue to wander in the trading range shown on the chart. The bulls can buy the stock if they want, bears can short it, and the “nowhere” crowd can sit on the sidelines, or…
This last group could consider a short strangle—a short out-of-the-money call option combined with a short out-of-the-money put option. (When the options have the same strike price, it’s called a “straddle.”) Basically, if the stock remains between the two strike prices during the lifetime of the trade, both options will expire worthless and the trader gets to keep the collected premium. Of course, a move significantly beyond one of the strikes could result in an open-ended loss.
Using RHT as an example, someone considering a short strangle may choose to sell options a little beyond the boundaries of the recent trading range—for example, short a $125 put option and a $155 call option.
What such traders are doing, essentially, is shorting volatility—they’re expecting the value of the options they’ve sold to decline as volatility declines. If that happens, they can buy them back at a cheaper price or let them expire worthless.
The thing is, whether you’re trading price or volatility, the name of the game remains buy low, sell high. In this case, there was some evidence RHT options may have been trading at a relatively low price—namely, because of low implied volatility (IV). While historical volatility measures the amount of past price movement in the underlying, IV is the market’s estimate of future movement embedded in an option’s price, and, all else being equal, the higher the IV, the higher the option’s price. So, options sellers generally prefer to short high-IV options: Sell ‘em high, and let ‘em decay.
But yesterday RHT appeared on a LiveAction scan of options with the biggest one-week IV declines:
Gold stars to those saying to themselves, “Of course IV declined from last week—RHT released earnings and had a sharp sell-off, to boot.” But the daily price chart also shows that RHT’s implied volatility yesterday was near the lower end of its range over the past several months—overall, not a condition that suggests its options are on the rich side.
Such circumstances may favor options buyers, in which case a long strangle—buying the out-of-the-money options instead of selling them—could be more appropriate. The following chart shows the profit/loss profile for a long RHT strangle consisting of the $145 call and the $125 put expiring on October 26. It’s a relatively low-cost, low-risk position—and it can make money regardless of which way the stock goes—but the trade-off is that it tends to be a low-probability trade, as well.
So there’s a big caveat here: Long-strangle traders need to have a good reason to believe a stock is going to make a move that’s big enough to compensate for the cost of the options. In this case RHT would need to push above $147 or below $123—the sooner the better, because options prices decay over time regardless of other factors.
When you’re an options trader, it’s one thing not to have an opinion about which way the underlying price will go, it’s another not to have an opinion about volatility.
Today’s numbers (all times ET): GDP (8:30 a.m.), Durable Goods Orders (8:30 a.m.), International Trade in Goods (8:30 a.m.), Corporate Profits (8:30 a.m.), Retail Inventories 8:30 a.m.), Wholesale Inventories (8:30 a.m.), Pending Home Sales Index (10 a.m.).