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VIDEOThe Limited Alchemy of Options
No amount of adjustments can bring a dead trade back to life.
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BL/AD
Let’s use the failure of Lehman Brothers as a demarcation of the capital-markets apocalypse. So while it’s true that the VIX had slid some 40% in the past 6 months, it still remains above the pre-Lehman levels of a year ago. But as Professor Warner has pointed out of late, names such as Apple (AAPL), Goldman Sachs (GS), or even the entire financial sector as represented by the Spyder Financial Select (XLF), have seen both the real or historical volatility of the stocks and the implied volatility of their options sink to 52-week lows -- below the levels they were prior to the Lehman failure.
For example, the VIX is currently running around 25%. But during the month of August last year, weeks prior to the Lehman collapse, it had been poking below the 20% level. By contrast, Apple’s current 20-day HV and IV are 24% and 28% respectively, which are both well below the 35%-40% readings being sported during August of last year. Likewise, the real and implied volatilities for Goldman and the XLF are also below their year-ago readings. In fact, for these stocks and many others, volatility readings are at multiyear lows.
Shrinkage
For traders that had become used to the elevated volatility of the past 18 months, the shrinking premiums have created performance anxiety. Owning options is no longer the clear and safe path to profits.
With both the broad indices and individual stocks moving into narrower trading ranges and risk perception on the wane, the impact of time decay and a decline in implied volatilities are posing a double whammy on option owners. And the majority of retail traders only buy options -- whether it's puts or calls -- as a way to make a directional bet.
The pain of shrinkage has been especially acute during this earnings season. Typically, options premiums or IV gets pumped up ahead of earnings in anticipation of the report, causing a significant price move. Then it will decline after the release, no matter what the results. The key to profiting from option ownership ahead of earnings is for the stock to have a larger percentage move than the options had been pricing or expecting. But alas, in many cases, that hasn't panned out: Goldman had it move the day prior and then just sat at $150 following the earnings release. Google (GOOG) options had been expecting a 6%, or $25 move, but the stock sank just $12 the next day.
This left many people holding options that were suddenly worth much less than they paid, and wondering how they'd get their money back.
Reflation Not an Option
Options are the veritable Swiss Army knife of trading tools, offering multiple ways to tackle problems. But there are limits to what they can fix, and re-inflating the crushed premium of an option is usually beyond repair. No alchemy of option adjustments -- whether it be rolling, switching, averaging, or flipping -- can put the juice back into option price that gets squeezed after an earnings report or the steady drip of time. Only a new, fresh move or news event will spark the premiums back to life.
In these cases, rather than watch the life drip while waiting for lighting to strike and bring the position back to life, it might be best to simply acknowledge that the trade didn't work as planned and move on to a new cadaver.
14 DAY FREE TRIAL TO OPTIONSMITH BY STEVE SMITH - ACTUAL OPTIONS TRADES & PORTFOLIOTwitter: @Minyanville/minyanville-markets-2
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