The Case of an Unexpected Event

I'm going to take a closer look at a specific case, starting with an unexpected event that translates into a sudden price change. This happened recently to Yahoo! stock. The following chart from iVolatility shows



the historical volatility and the implied volatility of Yahoo! over the past three months. Note how for a while the implied volatility was substantially higher than the historical volatility. Then a large overnight change of the stock price brought the historical volatility suddenly to extremely high levels. On the other hand, implied volatility actually decreased from there.

The following chart from BigCharts shows Yahoo! stock price over the past three months:



Here I use the Bollinger bands to see how the historical volatility (as measured here by the price standard deviation) suddenly increased as an effect of the overnight price drop after a long period of almost no change.

Let's try different trading strategies where one tries to buy volatility low and sell it high.

Let's consider first Yahoo! options expiring this month. Before the sudden drop the stock price of Yahoo! was gently fluctuating between $30.5 and $33. I want to consider options that were at the money during this period.

This is a chart of YHQHF, August call with $30 strike:



And this is a chart of YHQTF, August put with $30 strike:



One strategy would be to buy 50 YHOO shares and one YHQTF contract (I will explain later the reason of the 50:1 ratio). We are buying YHOO at $30.5 a share and YHQTF at 100 times $1.5. That means a total cost of $1,675, disregarding commissions. Now, if I sell the 50 YHOO shares just after the drop at $25.5 and the YHQTF contract at 100 times $5, I get $1,775. That is I make a profit of $100, a 6% gain. With a round trip commission of $0.01/share and of $2.00/contract the profit would be $97.5.

On the other hand if the price drop did not happen, I would close the position by selling the 50 YHOO shares at, say, $31.5, and the YHQTF contract at 100 times $0.75, for a loss of $25, that is a 1% loss.

Another strategy would be to sell short 50 YHOO shares and buy one YHQHF contract. Now we are selling YHOO at $30.5 a share and buying YHQHF at 100 times $2.25. That means that we earn $1,300. If we then buy 50 shares of YHOO to cover at $25.5 and sell the YHQHF contract at 100 times $0.1 our earning is $35.

Again, if the price drop did not happen, I would close the position by covering YHOO at $31.5 and selling YHQHF at 100 times $2.75, breaking even.

Note that if YHOO price were to go up instead of down I would not need to cover my short position at a loss because the call contract allows me to cover at a price slightly lower than the price I sold YHOO short.

This is the chart of YHQHZ, August call with $32.5 strike:



This is the chart of YHQTZ, August put with $32.5 strike:



Now I am going to buy 50 YHOO shares at $33 and one YHQTZ contract at 100 times $1.25 for a total cost of $1,775. If I then sell the YHOO shares just after the drop at $25.5 and the YHQTZ contract at 100 times $7.25 I am going to make a profit of $225, a 13% gain.

If the price drop had not happened I could have sold YHOO at $31.5 at YHQTZ at $1.75 for a loss of $25, a 1% loss.

Another strategy would be to sell short 50 YHOO shares at $33 and buy one YHQHZ contract at 100 times $2.25 which generates $1,425. If I buy 50 YHOO shares after the drop to close my short position at $25.5 and sell YHQHZ at 100 times $0.05 I have a profit of $155.

In the case the price drop had not happend I could have covered YHOO at $31.5 at sold YHQHZ at $1.25 for a loss of $25.

What about trading just options? Again, here I am considering only at-the-money options.

I could buy 4 YHQHF contracts at 4 times 100 times $2.25 and 4 YHQTF contracts at 4 times 100 times $1.5 for a total cost of $1,500. This type of strategy is called a long straddle. Just after the drop I would sell each YHQHF contract at 100 times $0.1 and each YHQTF contract at 100 times $5 for a total of $2,040 and therefore for a profit of $540, a 36% gain.

In this case, in the event the price drop had not happened I could have sold YHQTF at 100 times $0.75 and YHQHF at 100 times $2.75 for a loss of $100, a 7% loss.

I could as well buy 4 YHQHZ at 100 times $2.25 each and 4 YHQTZ at 100 times $1.25 each for a total cost of $1,400. After the drop I would sell each YHQHZ at 100 times $0.05 and each YHQTZ at 100 times $7.25 for a total of $2,920 and a profit of $1,520, a whopping 109% gain.

If the price drop had not happened, I could have sold YHQTZ at 100 times $1.75 and YHQHZ at 100 times $1.25 for a loss of $200, a 14% loss.

Categories: stock options, volatility, delta neutral
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