When Volatility Can Ruin Your Options Position

As volatility has reached low levels, its impact on stocks and options has been largely ignored until recently.

Volatility has often deterred investors from taking a position, but the FDA's announcement on July 28 on its intention to reduce nicotine levels in cigarettes drove down tobacco stocks nearly immediately. Philip Morris (PM) , the New York-based manufacturer of Marlboro and many other brands, experienced a swift pullback right after the announcement, said Ron McCoy, a portfolio manager of the LOWS Strategy with Covestor, the online investing company, and CEO of Freedom Capital Advisors in Winter Garden, Fla.

The stock dipped by 7% after the FDA announcement, affecting investors who used leverage in their positions. The spreads on Philip Morris "widened in excess of over 100% for at the money options expiring within three 3 weeks," he said. "What use to be a nickel spread now widened to in excess of $1."

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As of Tuesday afternoon, the stock had settled down "quite a bit and spreads tightened significantly," McCoy said.

When investors use leverage, they need to recognize that volatility spiking significantly could result in a squeeze on their position, forcing them to try and cover their positions in an already very expensive market where spreads widen significantly.

"It's significant, because it gives investors a preview of what will be coming at some point and it gives them a chance to reevaluate their risk level before its too late," he said.

While the swift pullback only occurred for a brief period that morning, the blowout in options premiums was eye-opening.

"Even after recovering six of the seven point decline by midday, the spread on at the money puts was still significant," McCoy said.

The August 18 $117 puts were bid at $1.25 and offered at $2.54. If an investor had put in a market order during a large decline, it would have been a costly move. Using limit orders can limit the amount of risk, even with index-based assets, he said.

"Even such contracts such as the SPDR S&P 500 ETF (SPY) , which are usually very liquid and have very tight spreads, can get blown out in really volatile markets," McCoy said.

The news thrust the implied volatility of the $117 August put of Philip Morris instantly from 14.78% to 21.63%, a 50% increase, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla.

"Tobacco stock investors should realize that they are going into a long phase of higher volatility era for the long drawn out political process for the tobacco regulations in the next few years," he said. "The prudent strategy is to embrace for the impact and stay long on the volatility, but not necessarily the stocks."

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