I have talked about implied volatility being considered “rich” or “cheap” when compared to historical volatility in the past.
A Little Background
Implied volatility is deemed to be rich if it is greater in magnitude than its historical volatility over the same time period. It is deemed cheap if it is below the historical. In previous discussions, I have talked about the potential pitfalls of simply selling rich IV and/or buying cheap IV. But, there are times when you can use this set up to your advantage.
Earnings Example
Let’s take a look at Solar City (SCTY).
SCTY reports earnings on November 5. This is the key point. As of October 9, the 10/31 weekly options have an ATM IV of ~59%.
The regular monthly November options have an ATM IV of ~66%.
My inclination is to buy the November and sell the weekly. Wait! Why would we buy the option with a higher implied volatility and sell the cheaper one?
Key Factors
Because of the pending earnings report and what the relative volatility is doing. We know to a very high degree of certainty that IV tends to increase (or at least stay steady) going into an earnings report.
The Nov contract contains the report where the 10/31 weekly options will expire beforehand. When comparing IV to HV we see that HV30 is ~46.5%. So, we have weekly volatility priced rich to HV.
Decay
If things stay as they are now, that should decay away much faster than the November options that I am long. Not only will they decay faster (as usual), the Nov will hold their value more than usual due to the pending earnings report.
