By Steve Papale
In honor of Memorial Day this Monday I have one fact to pass along. The Star Spangled Banner was written by Francis Scott Key during the War of 1812. He witness the shelling of Ft. McHenry, which defended Baltimore. The next morning he saw the flag still flying and he wrote the song. Pretty cool. Here’s to the men and women who put it out there to defend our country. Happy Memorial Day.
We saw last week that edge or expected profitability can be defined differently for different market participants. For some it’s based on the charts or technicals. For others it might be statistical. For a hedger, the edge might be in the value of the insurance the option provides. The cost is worth it.
One way options traders capture edge is by comparing implied volatility to the statistical volatility or movement in the underlying. Implied volatility telegraphs how the options market are seeing how volatile the underlying is expected to be from now until expiration. There are two ways options traders use this information.
First, a trader may believe vol is extended in one direction or another and take a position based on the expected move. This is a common way to trade volatility. However, as we have seen, vols can take a while to revert to the mean. Low vol for example can stay low for a while. Nothing earth shaking there. Just know the risk and how to manage it.
The second way we can use vol is to compare the IV with the underlying volatility. If there is a big enough difference , there may be edge to capture. For example, if IV is 20 but underlying is 15, options are priced as if the underlying has a 20 vol while only trading at 15. Now markets ebb and flow and IV can move above or below underlying vol. But some markets have a long term relationship between IV and underlying that shows either overvalued or undervalued. In those markets we can either sell options that are overvalued or buy the ones that are undervalued with the goal of capturing edge.
Next week let’s look at some practical aspects of this approach.