Apple: A Lesson in Trading Volatility

To say that the markets have been volatile recently would be an understatement. So let's take a fresh look at this roller coaster environment to better understand what's happening and how we might be able to profit from it.

Understanding the VIX

The most widely quoted volatility index is the CBOE (S&P 500) Volatility Index (VIX). While the VIX represents investor demand for options -- both puts and calls -- you can also view the VIX along the spectrum of market mindset:

  • Complacency: Low VIX / Fear: High VIX
  • Greed: Low VIX / Fear: High VIX
  • Conventional wisdom says that the VIX should trade in a range of 20 to 30, with 30 being the level of "oversold" markets and 20 or below being "overbought" markets. Let me dispel that as a statistical myth.

    The average level for the VIX is about (and I am rounding here) 19.15, with a standard deviation of 6.35. Thus, the normal range, if you look for one-standard-deviation moves, is between 12.80 and 25.50. As of the close on Monday, Oct. 6, the VIX stood at 52.05 and currently, it's in the 70s. This is an extremely elevated level that is several standard deviations above the mean.

    (Don't miss " Options Know-How: Morgan Stanley, Google")

    Profit from Volatilty With Options: Apple

    I could not think of any better stock that represents investor sentiment and hedge fund activity than Apple ( AAPL).

    While Apple stock has fallen significantly since Sept. 19, volatility for the stock has skyrocketed. This is depicted in the following Bloomberg screen:

    Click here for larger image.
    Source: Bloomberg
    Here are a few observations from this chart:

    1. The short term volatility, defined by the 10-day (or two-week) historical volatility has climbed 69% since Sept.19 to a level of 126.68%. Compare this to the volatility for a consumer staple company like General Mills ( GIS), which was slightly elevated over the same period of time, but stood at a mere 25.05%.

    Clearly, investor worries and forced selling by hedge funds have contributed to Apple's skyrocketing volatility.

    2. As Apple's historic volatility has gone up, so has Apple's implied volatility for call and put options. Each has risen from around 50% to about 111% during the period in the above chart. (Implied volatility is a variable in the Black Scholes model for options pricing. If all other variables, such as stock price, interest rates, dividends and time remain constant, then an increase in volatility will equate to an increase in both option and put prices.) This chart is telling us that there is more fear and risk being built into the pricing of Apple by options buyers.

    So can we take advantage of the increased volatility in Apple?

    Yes. Here are two ways to do it: calls and puts.

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