Experienced options traders already know how volatility impacts options. But from recent articles and comments I've read, there seems to be this misconception that if you sell a call against a stock like Apple (AAPL) when volatility is high before earnings, you'll make money simply because the implied volatility will fall after the news is out.
So here's a question. Let's say that as Apple's implied volatility rises into earnings, I give you the choice of selling a call or a put. Which is most important to how profitable the trade is - a plunge in implied volatility or whether you chose the call or a put?
If the stock moves, it's the direction you chose that makes all the difference. Changes in implied volatility are only meaningful if the option you sell stays close to the money.
If the stock falls, you'll make money on your short option, but that's mostly because it becomes an out of the money call. If the stock rises, implied volatility may fall, but your short option position isn't going to benefit.
Short Option Position Becomes Profitable as Volatility Rises
Here's an example: Let's say back on July 18 with AAPL at around 373, you sold an August 370 covered call on your AAPL shares for 16.55 just before the July earnings report. Implied volatility was relatively high (for the era) at around 34%. But after the earnings announcement, the stock took off.
Here's the value of your short call as it traded while the stock rose to over $400 in late July.
But implied volatility? That fell off a cliff - at least for awhile. Check it out, your short option position became profitable as volatility soared. Imagine that.
The Volatility Factor
How much will a change in implied volatility influence an option? The options vega measures its sensitivity to changes in volatility. Here's what it looked like for that specific option.
The lower the number, the less volatility influences the price of the option.
As time went by, volatility impacted the option price less and less. That's normal. What saved your butt? (Assuming you didn't want your stock called away ...) It was that the price of the stock fell. Notice your short call became profitable when the implied volatility was higher than when you sold it.
That time going by? That helps a short option position, too, but not as much when a short option is in the money. Notice how the options theta (its sensitivity to time decay) didn't start giving your short position a lift until early August, when the option became out of the money once again as the stock fell below $370.
Selling volatility when it's high and buying it back when it's low will work out fine if the options tend to stay near the strike price - or perhaps if you're buying or selling a specific option spread. Otherwise it's these other factors that determine the value of the short option you sold.
Or as Charles Cottle wrote (in big bold type) in his book Options The Hidden Reality, "volatility is not money!"