Option activity and trading advice over the past week seems to have been dominated by hedging activity, such as overwriting, buying puts or even replacing long stock holdings with call options. Traders have been trying to take advantage of the recent run-up to secure some profits and reduce risk.
But now that's done and the market has settled down, so it's time to search for some fresh opportunities. Naturally, options traders always gravitate toward high-volatility situations. These provide the action needed to turn short-term trading profits.
One stock with volatility that has shot up is
Research In Motion
. The stock tumbled some 22% in the last week to an intraday low of $72.19 on Tuesday and has since recovered somewhat, trading above $80 in recent trading Wednesday. The implied volatility (IV) of the November at-the-money options has shot up to 75% from 50% one week ago and is twice where it was 30 days ago.
While the initial catalyst moving Research In Motion was talk of customer dissatisfaction with a new product, the real item pumping up volatility is the impending decision on a patent infringement lawsuit brought by privately held NTP Inc. Whichever way the ruling goes, the stock is likely to make a significant move, because the ramifications are huge.
Research In Motion lost the case the first time in 2002, resulting in an injunction banning BlackBerry sales in the U.S. The injunction was stayed pending the outcome of the appeal, but it's likely to be reinstated if Research In Motion loses. At the time, the company was also required to set aside 8.55% of U.S. sales as a royalty rate for NTP until the case is concluded. Those funds would go back to Research In Motion if it wins the case; that would create the double bonus of a cash windfall and the removal of giant legal question mark.
Even at the current level, I don't think the options have fully priced in the potential move. I expect implied volatility to keep increasing as the judge's decision draws closer and its ramifications come fully into focus.
Therefore I think it makes sense to purchase a straddle in Research In Motion. Getting long a straddle, which is the simultaneous purchase of a put and call with the same strike price and expiration date, is a bet that IV will increase and/or the underlying price will move beyond the cost of the straddle. I think the current situation in this stock offers the possibility of both a substantial increase in implied volatility and a price move beyond the break-even points. Here are the two main challenges:
- Justifying paying the current premium. Is there good reason to believe IV can rise further? And will the potential move go beyond the break-even points?
- Timing. In most situations IV doesn't perk up until a decision or event is imminent, but there are plenty of situation where "any day" turns into weeks away.
Expect a Bigger Move Later Than You Think
has been involved in a variety of patent suits, so it provides a reasonable comparison and template for how Research In Motion options might behave. Early this year as Rambus awaited a ruling, the IV of its options climbed from 45% to 125%. Once the word came down (the ruling was in its favor), the stock did move beyond break-even, giving the straddle a profit despite a collapse in the implied volatility. I see no reason why the implied volatility of Research In Motion won't have the potential to rise above 100% heading into the event.
provides a great example of the importance of selecting the right expiration date. Its IV rose from around 50% in June to a peak of 241% on Sept. 17, only to quickly fall below 100% on Sept. 28. That was the day after positive results were released; the stock jumped 65% to $38 on the news.
Atherogenics options recorded its highest implied volatility a week before the actual "event" occurred, because Sept. 17 was an expiration day. For a graphical depiction,
click here. This illustrates how the expectation of an impending event tends to give options a horizontal skew (the near-term options are more expensive than the longer-dated options), and also highlights the importance of choosing the right expiration period. Even though Atherogenics started to work higher several days before the results, anyone who bought September call options came up six days shy of reaping much larger profits.
For this reason, it makes sense to buy options with more time remaining than might be actually be necessary, just in case the event is delayed beyond the expected date. Because implied volatility tends to expand right up until the actual event, it should offset any time decay during the holding period.
So even though the Research In Motion ruling is expected any day, I would look to buy the options with a January expiration. With shares trading at $81.50 on Wednesday, you can buy the January $80 straddle for $18.80 ($10.50 for the call and $8.30 for the put), giving you a break-even of $98.80 and $61.20. While this is fairly expensive, the implied volatility is 65%, a nice discount to the 75% currently awarded to the November options. If the ruling still has not been delivered by Dec. 10 and IV climbed to 100%, the straddle would have a theoretical value of $19 even if the stock still stood at $80.
Also, by using longer-dated options, one establishes a position with a positive gamma from which short-term trades or cost-reduction sales using the more expensive front-month options can be executed in response to movement in the underlying share price. For example, if Research In Motion trades above $85, you might consider selling some December $90 calls to capture some premium and reduce the position's cost. Likewise, if the shares fell to $75, you could sell some December $70 puts. Essentially, you will be legging into a diagonal calendar spread. The maximum profit will be limited, but your costs and risk will have been greatly reduced.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to