Follow The Volatility

Similar to the value that comes from “following the money,” it can also be useful to investors to follow the volatility. Watching activity in the Options market can often yield valuable information; and, to do so, we can look to an indicator known as Implied Volatility (IV).

Essentially, IV “implies” that a stock’s price will experience some sort of price movement (often a dramatic one) at some point in the future. Since Options (in this context) can be considered a levered bet, often employed by institutional traders and hedge fund managers (i.e. “people in the know” who wish to place big bets with defined, potential, losses), watching Options market activity can be very beneficial to the individual trader/investor.

One of the best places I have found for Options information is optionsXpress. Though one must have an account to access the company’s, tools, once an account has been opened there are no special fees or obligatory requirements (e.g. placing a certain number of trades per month, etc.) imposed on clients for using the tools. The tool that I use to find Options volatility information is called “Dragon” and it is an extremely versatile tool that scans the universe of Options to find such things as: High Options Volume, High Open Interest and Big Daily Change in Implied Stock Volatility. This is just a partial list of the features the tool offers, and it is not limited to Options, certain stock criteria can be scanned as well.

When I ran my most recent scan for Big Daily Change in Implied Stock Volatility, I was provided with a list of approximately fifty stocks that had seen a rise in IV. The following table lists the top four stocks on that list.

Big Daily Change in  Implied Stock Volatility Screen

As we can see in the above table, TRIB, NAVB and RSH all saw increases in IV; whereas, BPI saw a decline. According to Investopedia, the definition for IV is:

The estimated volatility of a security’s price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets.
Source: Link

From the definition we might conclude that prices for the stocks with increased IV stand to decline [a “bearish” indication] in the days and weeks ahead, but this would not be entirely accurate. Since an increase in a stock’s IV is caused by an increase in Option prices (which is caused by an increase in demand), the prices of the three stocks listed above could just as easily appreciate in value. With regard to RadioShack Corp. (RSH), however, CNBC reported the following on Thursday, July 11, 2013:

RadioShack shares fell 7 percent on Thursday after a report the electronics chain is considering hiring a financial adviser as debt comes due and sales are falling.

RadioShack plans to entertain pitches from financial advisers in the coming weeks as it faces looming debt maturities, escalating cash burn and bloated inventories, according to trade publication Debtwire, citing unidentified sources.

Source: Link

So, with regard to RSH, I feel it safe to assume that traders are speculating that the company’s stock price is going to decline in value (possibly going to zero). IV could have also been affected by investors buying Puts to protect the RSH positions they currently hold in their portfolios. Either way, RSH is one to watch for price declines in the coming days or weeks.

As for the other stocks with increased IV, an increase in the price of Call Options can also affect IV; so, it is possible that traders may be betting that positive news will drive the stock prices higher. I know that TRIB announced an increase in its dividend recently, but I highly doubt that the announcement caused the increase in IV.

Given that the increases in IV are driven by increases in the prices of the Options on the underlying securities, big investors are likely placing BIG bets on directional changes (either up or down) in the prices of the underlying securities. At this point I should note that increases in IV are not a failsafe when it comes to placing bets on stock price moves. Given that the “people” buying the Options contracts are making certain assumptions about potential stock price movements, those trades are subject to certain errors and misjudgments — after all, people are not infallible. That, said, however, watching for increases in IV can be a very effective trading strategy, especially given that the people behind the trades are usually those who have access to much more information than the individual trader or investor.

For the long-term investor, watching for increases in IV on stock positions held in one’s account can prove to be a very effective way to protect one’s positions. Given that increases in IV occur around the time (and, often, before) big news events occur, it can prove beneficial to the investor, who may fear there will be a negative news event at some point in the future on a particular security in the investor’s portfolio, to watch for changes in IV. This information often affords the investor some advanced warning, which affords the investor some time to take the necessary steps one must take to protect her or his position (e.g. tightening trailing stops, purchasing Put protection etc.).

Disclosure: I own shares of BPI, RSH, and NAVB, indirectly, through the Vanguard Total Stock Market (VTI) ETF.

Disclaimer: The content on this site is provided for general educational and informational purposes only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author and do not necessarily represent the opinions of sponsors or firms affiliated with the author. Any action taken by you as a result of information, analysis, or advertisement provided on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

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