Updated: Aug 24
As an options trader you need to be familiar with implied volatility and its implications for the options premium. More often than ever traders underestimate this variable and do not understand the behaviour of the options in their portfolios.
That is why I want to share with you a volatility trade I did on Citigroup Inc. (C) on Friday the 27th of January 2023. It was a great position as I made almost 50% profit in 45 days. What was remarkable about this trade was the fact that I had little if not zero risk considered the low value of implied volatility when I entered the strategy.
Purchasing Call and Put Options at Discount
I was analyzing the price action of the underlying security in January and could notice un uptrend and a substantial reduction in the value of implied volatility (IV). I saw an opportunity there that does not come often. I could purchase options at discount as IV is one of the main components of the options premium.
I decided to open a delta neutral strategy known as the Straddle to benefit from a likely increase of the implied volatility value. A Straddle is normally considered an expensive strategy because as an option buyer you are purchasing time value and implied volatility. In this specific case, I purchased the strategy on Friday the 27th of January with a maximum investment limited to $1258 and a potential unlimited profit in either direction if volatility increased in the market.
I purchased 2 contracts of the $52.5 call option expiring on the 16th of June 2023 and 2 contracts of the $52.5 put option expiring on the 16th of June 2023. Both puts and calls had a remaining life of 140 days. However, my goal was to be in the trade for a limited amount of time because of the negative impact of time decay on the position. In fact, at the time the trade was opened Theta was -$4.31 meaning that I was losing this amount daily for effect of the passage of time. I knew I could be in this trade for no more than 40-50 days and then had to sell back the strategy even with a loss if the stock did not move enough.
Conversely, the Vega in this position was +$50.45 meaning that I could make this amount for every 1-point increase in the value of implied volatility. And this is what I was actually seeking to profit from the Straddle. Another key piece of information I want to give you is the IV% values of the two options purchased. At the time I started the trade the $52.5 call option had an IV value of 24.08% and the $52.5 put option had an IV value of 25.36%.
Implied Volatility Increase Vs Passage of Time
Now I had to be on this trade a little longer than anticipated as the underlying traded in a range for the full month of February. However, from the 9th of March there was a sudden movement downwards of the stock with a substantial increase in implied volatility. On Monday the 13th of March, I decided to exit the strategy collecting $615 in profit. This was due to the anticipated increase in the value of the implied volatility and the sudden decline of the stock which created the conditions for a favorable trade.
It is interesting to compare the IV values at the beginning and at the end of the strategy. At the end, the $52.5 call option had an IV value of 34.66% and the $52.5 put option had an IV value of 35.21%. The call options experienced a 10.58% increase in IV and the put options experienced a 9.85% increase in IV.
In other words, the increase in implied volatility more than offset the reduction of value due to the passage of time (45 days that I was into the trade) and explains the 50% profit that was achieved on this trade.
Hope you enjoyed this strategy!
I’ll see you in the next release of the options trading diary.