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When Volatility is Your Friend

Jeff Miller

Academics will tell you that volatility is bad in and of itself. It’s like an original sin. They think something that moves a lot is risky. Something that has gone up and down is hard to incorporate into a mathematical model, and academics don’t like things that mess up their models. Hence all the footnoted assumptions in academic papers describing why (if you know what you are reading) the models won’t actually work in the real world. When asked, academics are likely to say that things like skewness, risk aversion, valuation aren’t elegant to model, so they fix all those variables to calculate a security price at a given point in time.

Option pricing models like Black Scholes (the most commonly used model) have to make future assumptions to price a security today. Many people who have studied these models know they work pretty well for valuing embedded options in long-dated securities like convertible bonds, but have more limited applications when it comes to near-term pricing in volatile markets. People use the models anyway because everyone else does and because the models often work well. You can trade derivatives on the various pieces of a model’s outputs, such as implied volatility, gamma, delta, etc. So long as everyone is using the same model and you get the direction of the trade right, it works out fine most of the time.

But there is a cost to the simplification and assumptions. A key portion of the Black Scholes model is an estimate of the future volatility between now and the expiration date of the option. And given that there aren’t a lot of good ways to do that, most market participants use past volatility to estimate future volatility. And therein lies our opportunity …

A Crazy Little Thing Called Beta
What if a stock’s volatility is in the recent past, like yesterday? And what if the volatility was to the downside, meaning that the stock price went down. What then? Again, your business school professor will tell you that this is now a riskier stock. Historical volatility is up. Yet as an investor, the price of a company just got cut significantly. How is it more risky NOW than it was last week? Because beta has increased—and academics don’t like that. Less is more to them.

But as value investors, we like high beta, so long as it is downside beta (that is, a stock dropped), the drop just happened, and we didn’t own the stock yet. This gives us a chance to buy a stock cheaper. (Conversely, we love high beta if it is upside beta on a stock we own.)

A Hypothetical Illustration of How it Can Work
Here’s a hypothetical trading example that illustrates how we could utilize options strategies within our opportunistic value approach. A company we follow closely but don’t own runs into a regulatory issue in a country from which it derives about one-third of its revenues. The day before the news comes out in a state-run newspaper, the stock closes at $136 per share.

Day 1: A newspaper article questions the company’s sales practices (allegations the company denies). The stock trades as low as $108 before closing at $115. The move gets our attention, but we don’t do anything. We have a three-day rule when a company has a big selloff—wait three days for the selling to run its course, then buy. (This works more often than you might think it should, but it’s actually based on the mechanics of the way market participants get into and out of positions.)

Day 2: The company’s main regulator in the country in question announces it is opening an investigation into the company’s sales practices. The stock trades as low as $68 before closing at $85. Now things are interesting. We do some work and estimate that if this government completely banned the company from ever doing business in its country again, the stock would be worth about $70 a share. Put another way, if we took all the company’s revenues from this market (again, about one-third of its total revenues), the rest of the company would be worth about where the stock was trading. But we believe a ban on the company was unlikely, since the government has recently given it more operating licenses. We believe it is much more likely that the government would require the company to pay some big fines, make a statement of regret for its actions, and charge a bit more for its products to give the local competition a leg up.

Day 3: The stock starts to sell off again, trading down in a fairly orderly manner throughout the morning. Now, it needs to be noted that options are priced using a normal distribution curve. This basically means that the main academic model, Black Scholes, assumes that a stock is equally likely to move up or down and that the probability distributions are equal as well (think of a nice bell curve). However, this stock just went from $140 to $85, and we could wipe out a third of its business and not have much downside. Our view of the probabilities is very different than the market’s, and the recent volatility enables us to extract some value from the situation.

So, we buy a 2% position at $77, near the day’s lows. We simultaneously sell a roughly equivalent amount of February 90 calls for $4 and February 65 puts for $4. This means we are obligated to add to our position at an effective cost of $61 ($65 strike minus $4 premium we collected) or sell our position at $94 ($90 strike plus the $4 premium we collect). If the stock stays above $69 (our purchase price of $77 minus the $8 in total premium we collected), we’d make some money. Again, we think $70 is the burndown value of the company, so we are okay with this. If the stock goes below $65, we’d be adding to our position at a low price. If the stock rises to $90, we’d make $21 per share: $8 from selling the puts and calls, and $13 from the stock price appreciation, or nearly 27% in about a month if we hold them to expiration. Not bad. But there is a different reason we like the trade: We’d make about 11% if the stock didn’t move. The market is pricing future volatility so high, even though the stock has already fallen from $140 to our price of $77, that if the stock price did NOTHING but stay right where it is, we’d make more than 10% in about five weeks. You have to love those odds. We’ve always believed when you get a good hand, you play it. Over time, the odds will be in your favor.

By taking advantage of flaws in the way the options market estimates volatility, we have opportunities to establish positions in companies we like at much lower prices than if we simply bought them outright. This is why we believe volatility is not a sin; often, it can be a friend.

The hypothetical illustration has been provided for illustrative purposes only and is not intended to project or predict the outcome of any particular investment or strategy. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors. Options strategies (including the purchase and sales of calls and puts) entail additional risks and may not be suitable for all investors. Unusual market conditions or lack of a ready market of any particular option at a specific time may reduce the effectiveness of an option strategies, and for these and other reasons, an option strategies may not reduce the portfolio’s volatility to the extent desired.

The Black Scholes Model is a widely used model for determining fair prices of options. Skewness refers to the asymmetry in the normal distribution of a set of data. Delta measures the sensitivity of an option to its underlying stock. Gamma measures the change in delta. Implied volatility is the estimated volatility of a security’s price.

About Options: A call option is an agreement that gives the purchaser the right—but not the obligation—to buy shares of a stock at a certain price, during a pre-specified period. If the purchaser decides to buy the shares at the specified price, he or she is said to “exercise the option” A put option is an agreement that gives the purchaser the right—but not the obligation—to sell shares of stock at a certain price, during a pre-specified period. Covered call writing involves selling (or “writing”) a call option against stocks or stock provisions that the writer holds. An option premium is the money that the seller of an option receives from a buyer. If the stock price falls, the premium can offset a portion of the stock price decline. The writer keeps the premium regardless of whether the buyer exercises the option or not. The strike price is the price the stock must reach before the buyer can exercise the option.

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