In basic terms there are only 2 types of options you can trade, Calls and Puts. As a buyer of options you always want the underlying stock to go up if you buy calls and down if you buy puts.
Determining which way a stock is liable to go is the challenge. However if you know a stock is going to move strongly in one direction or another, then you might consider buying a straddle.
To buy a straddle you simply by the At/Near-the-money Call and the At/Near-the-money Put option. In order to benefit from using this strategy, you would need the premium of one of your options to increase by more than both the Call and Put premiums put together.
Other Important Stock Option Implied Volatility Considerations
If the announcement is good and the stock rises strongly my call options will rise strongly and I can still profit, even though my put options will probably be worthless.
If the announcement is bad and the stock falls strongly my put options will rise strongly and I can still profit, even though my call options will probably be worthless.
As a buyer of a straddle we do not really care which way a stock moves, so long as it moves far enough in one direction for us to profit on the trade overall.
However, there is one important thing to take into account here and that is Implied Volatility.
Implied Volatility, which is in fact a measure of potential ‘future’ volatility, can inflate the time value of options greatly. As a buyer of options and in particular At/Near the money straddles we need to be careful of this because should the underlying stock ‘not’ move strongly in either direction after we buy the straddle, this Implied Volatility can fall or deflate and therefore erode the value of our options.
As we have purchased two lots of options (calls and puts) to create the straddle, this can be either a double whammy if we’re not careful.
A great indicator that we are able to use to warn us of high implied volatility is Bollinger Bands. When the bollinger bands are wide (expanded) in relation to the past few months, than this can suggest that implied volatility is high and options may be ‘overvalued’.
June’s implied volatility is presently at 40 while August’s implied volatility is at 36. You can not calculate the spread’s volatility using these two months as they are. You must either bring June’s implied volatility down to 36 or bring August’s implied volatility up to 40. You may wonder how you can perform this.
Actually, you have the tools right in front of you. Use the June vega to decrease the June option’s value to represent 36 volatility or use August’s vega to increase the August option’s value to represent 40 volatility. Both ways work so it does not matter which way you choose.
Let’s use some real numbers in order that we may work through an example together. Let’s say the June 70 calls are trading for $2.00 And have a.05 vega at 40 volatility. The August 70 calls are trading for $3.00 And have a.08 vega at 36 volatility. Thus the Aug/June 70 call spread will be worth $1.00.
A warning sign here is when the bands have been wide/expanded and have started turning inward or contracting.
This can show that the implied volatility is now declining and ‘dragging’ on the premium (time value) of the options on that stock.
As an option buyer, we ideally like to see the bollinger bands coming from a ‘narrow’ contracted state and starting to ‘flare’ out.
This can be an indication that implied volatility is on the increase. This will support the premium of our options and even increase their value, without the underlying stock needing to move substantially.
Please note though that this insight should only serve as a guide and is founded on my own personal observations and experience, yet if used in the context of an effective overall strategy/system, it will surely help to stack the odds of success in your favor.