Term Structure of Implied Volatility

Changes in implied volatility provide information on options market participants’ expectations regarding future fluctuations in returns on a specific stock.

For the purposes of this discussion, we will analyze volatility in the stock price of the Great Canadian Gaming Corporation (GC), which closed at $23.79 on February 24, 2017.

The following graph shows the volatility curve (the “volatility smile”) of each expiration based on the strike prices of GC stock options.

As you can see, the volatilities for the April, July and October expirations fall within a relatively narrow band of 25% to 28%. However, the March expiration is notable, as it floats far above the others with a curve in a range of 32% to 44%.

Graph 1. GC Volatility Curves

Graph 2 illustrates changes in the implied volatilities of call options and put options with a strike of $24 for each expiration.

The changes in volatility from one expiration to the next have much to say about market perceptions of how the risk changes over time: in other words, the volatility spreads over time. This is called the term structure of implied volatility.

Graph 2. Term Structure of Volatility in GC

In the case of GC, the option with the March expiration clearly stands out, with an implied volatility of close to 34% compared to approximately 27% for the April expiration. This apparent discrepancy, at first glance, suggests an opportunity for profit. We could be tempted to establish a horizontal spread by:

• Selling the March call options, which appear to be overvalued, and
• Buying the April call options, which appear to be relatively undervalued (we could apply the same strategy with put options).

This may allow us to profit from the difference in the volatilities of these two expirations if the price of GC is relatively stable until the March expiration.

However, if this appears to be too good to be true, perhaps we should question it. Indeed, when we observe this kind of discrepancy, it is worth being cautious and investigate the reason behind it. There are no free rides in finance. After some quick searches on the site TMX Money (http://www.tmxmoney.com/en/), we find out that the company will be releasing financial results on March 7, 2017. So there it is, we have found the reason for our spread!

Therefore, the market is expecting more price swings than usual after the company reports its latest financial results. This is what we see reflected in the option prices, through the level of implied volatility.

So setting up a horizontal spread is not going to be as easy as we initially thought, since this strategy seeks to profit from relative price stability until the expiration of the options written. Yet, the market is expecting that the price of GC will fluctuate more than usual.

So what should we do?

If you believe that the market is on the wrong track, then you should go ahead anyway, since you will be rewarded with a higher premium on your call options when you sell them. On the other hand, you will run a higher risk of incurring losses if the price of GC fluctuates considerably after the company releases its results.

You can use the volatility curve (the “volatility smile”) for March to set up bullish spreads by writing low-volatility calls (or puts) and selling higher-volatility calls (or puts). You can also set up a ratio call spread (or a ratio put spread) by buying low-volatility options and writing two or more options of the same type for each contract bought. This will allow you to profit from this volatility spread by selling more high-volatility options. Remember to carefully assess the risks before applying this kind of strategy.

So the situation provides several opportunities. Three things may happen: (1) the market price of the stock will fluctuate more than expected, (2) the price will fluctuate less than expected, or (3) the price will not fluctuate at all.

If you think that the price of the stock will fluctuate more than expected, then you could buy, among other things, a straddle with a strike of $24 and then, the day after the company releases its financial results, sell at a profit if the price fluctuates more than the value of the straddle in either direction. You can also set up a strangle for greater leverage, or a butterfly spread, or a reverse condor.

If you think that the price of the stock will fluctuate less than expected, or not at all, then you can sell, among other things, a straddle at a strike of $24, and buy it back at a profit the day after the financial results are released if the price fluctuates less than the value of the straddle. You can also set up a strangle or a butterfly spread, or a condor.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing a option strategy.