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Don Kaufman here. |
Today we're going to unravel the mystery of implied volatility – the sneaky little gremlin that's probably been munching on your profits without you even knowing it. |
Buckle up, because this roller coaster ride is about to get wild! |
The Volatility Villain: Meet IV |
First things first – what in the name of Elon Musk's fortune is implied volatility (IV)? |
Imagine you're at a carnival, trying to guess how many jellybeans are in a jar. |
That's kind of what the market is doing with stock prices. |
IV is like the market's collective guess about how much that stock price might wiggle around in the future. |
The higher the IV, the more the market thinks the stock will bounce around like a kangaroo on caffeine. |
For example, ASML Holdings (ASML) released earnings a day early, during market hours of all things and the stock plummeted by more than 15%. |
At one point the IV was 70-75% give or take, the market was expecting it to move another $40 points between now and Friday. Which was on top of the +135 points it already made. |
However, volatility eventually came in, with the ATM options closing at an IV of 61%, and the market implying a $32 move for the rest of the week. |
Why Should You Care? The Price is Right... or Is It? |
Here's the kicker… |
IV is baked into option prices faster than your grandma's famous apple pie. |
When IV goes up, option prices tend to rise – both calls AND puts. When IV drops, option prices often fall. This happens regardless of which way the stock is moving! |
The Great Oil Debacle: A Cautionary Tale |
Let me spin you a yarn that'll make your head spin. Back in the disco-loving 70s, some smarty-pants traders correctly predicted an oil price spike. |
Feeling like the next Warren Buffett, they sold some puts, thinking they'd buy them back cheaper when oil prices rose. |
Plot twist: When oil prices skyrocketed as predicted, these traders were shocked to find their puts were worth more than their initial sale price. |
Why? |
Because they ignored our sneaky friend, IV. The market freaked out, volatility shot through the roof faster than John Travolta's career, and suddenly those puts were more expensive than a barrel of oil itself! |
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Breaking Down the Voodoo: How IV Affects Option Prices |
Let's get into the nitty-gritty: |
The IV Seesaw: Often, when stock prices fall sharply, IV rises. It's like a seesaw – when one end goes down, the other goes up. This is why put options can become incredibly expensive during market crashes. Earnings Magic: Ever noticed how options get pricier right before earnings announcements? That's IV at work! The market's anticipating big moves, so it pumps up the IV, which inflates option prices. The Crush: After big events (like earnings), IV often drops dramatically. This is called "volatility crush," and it can turn your winning directional bet into a loser faster than you can say "implied volatility."
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Don's IV Survival Toolkit |
The Vol Check: Before making a trade, always check the current IV. Is it high compared to its historical range? Low? Average? This context is crucial. The VIX Trick: Keep an eye on the VIX index. It's like a fear gauge for the S&P 500. When the VIX is high, options are generally expensive across the board. IV Rank and Percentile: These tools tell you how the current IV stacks up against its past. High IV Rank? Options are expensive. Low IV Rank? They're relatively cheap. The Greeks: Pay attention to Vega. This Greek tells you how much an option's price will change for every 1% change in IV. High Vega means you're more exposed to IV changes. Volatility Skew: Different strike prices can have different IVs. This "skew" can help you choose which options to trade.
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Putting It All Together: The IV Dance |
Here's where the rubber meets the road: |
High IV: Consider selling options (like credit spreads) to take advantage of expensive premiums. Low IV: Buying options might be more attractive, as they're relatively cheap. Earnings Play: Be cautious of buying options right before earnings – you're paying a premium for that high IV. Directional Bets: Remember, being right about the stock's direction isn't enough. If IV drops significantly, your winning bet could still lose money.
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The Bottom Line |
Ignoring implied volatility is like trying to drive with your eyes closed – you might get lucky for a bit, but eventually, you're going to crash. |
Always factor in IV when making your trades. It's not just about where the stock is going, but how crazy the market thinks it might get along the way. |
Remember, when trading options, volatility is the spice that can either make your trade delicious or leave a bad taste in your mouth. |
Master the IV dance, and you'll be grooving your way to more informed (and hopefully profitable) trades in no time! |
To your success, |
Don Kaufman |
P.S. Tech and AI stocks took a hit on the chin today after ASML's earnings release. Blake Young believes we're going to have a MASSIVE sector rotation in the coming weeks. If you want to find out what it is, make sure to click this link and register for his live market briefing that's happening this Thursday at 1 PM ET. |
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