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How Should I Approach High Implied Volatility Stock Options?

Posted by Pete Stolcers on July 22, 2010

Option Trading Question

Every month we can always find options with very high implied volatility, especially from pharmacuetical companies that are waiting for FDA approval. Is there any proven way to profit from this situation regardless of the decision of FDA? (please, don't recommend a straddle)

Option Trading Answer

Anytime you see a spike in implied volatility it tells you that uncertainty has entered the picture.  The professionals that make markets in that underlying attach a probability to the various outcomes and they calculate the impact on the profitability of the company. Then they price the options using complex proprietary algorithms. They have a staff of analysts running through the numbers and making phone calls within their network to try and find a shred of information that will give them an edge. I’m sure in some cases they have an employee in the courtroom waiting for the verdict to be read. In the end, I can’t compete in this arena. These large institutions have millions to throw at the event, I do not.

I run from these situations and I view them as a crapshoot. If you see a steady climb in IV and the stock has not moved, it means there is news pending.

Look for situations where the outcome is predictable - like a stock with a nice tight trading pattern and consistent earnings. Form an opinion, take a stand and know when to admit you are right or wrong (target, stop).

Option Trading Comments

  • On 12/24, karneyli said:

    I’ve never done this myself before… but I supposed you could just play it as a long straddle (buy a put and a call option) that are OTM.  And then after the direction clear after the announcement you can sell the other leg of the straddle.  And decide what to do with the winning leg.

    The problem with this approach is, if the news doesn’t move the underlying price drastically enough, you’ll end up having both legs lose money when you need to sell them off or expire worthless.

  • On 05/04, Jeff said:

    If you are a gambler type as you seem to have explained then it’s better to lose a little on that example, BUT, I believe in law of averages personally, and if you are not just going wild and are placing high probability trades; then sooner THAN later you will get a few in a row that will break HARD either way and win.
    A lot depends on what your fees are also, if you do this multiple times.

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