Tuesday, March 2, 2010

Crazy Biotech Bid Ups

One of the more common methods of volatility analysis used by option traders is that of comparing historical volatility to implied volatility. The efficacy of this approach hinges on whether or not the past can be a good predictor of the future. In other words, can a stock's price behavior over the last 30 days be a good indicator of its behavior over the next 30 days? If you think it may, you're probably a proponent of this form of analysis. The biggest fly in the ointment however, is the fact that there are often events looming on the horizon, such as earnings or FDA announcements, that will drastically influence a stock's volatility. While these have no influence whatsoever on historical volatility, they will surely cause some noise with implied volatility.

In anticipation of these known events implied volatility will almost always be trading at elevated levels compared to historical volatility. This does not automatically make options a slam dunk sell. Take the current case of Medivation (MDVN). Though its 20 day historical volatility sits at a mere 40%, implied volatility has risen to an astronomical 260% (click to enlarge).

[Source: Livevol Pro]

Though the casual observer may suspect the options are a raging sell, there's more to this outrageous bid-up than meets the eye. As with most biotechs, MDVN has a blockbuster drug currently being tested which represents a potential windfall profit generator if approved. Due to the huge ramifications of this study, its results could cause the stock to swiftly double or halve. Just as with most binary events, options get bid up to extremely pricey levels beforehand.

We're I betting man I'd probably fade the volatility spike with a limited risk short vol strategy like a condor. Though there's enough juice in the OTM puts all the way down to the 15 strike, the upside calls top out at 75.

With setups like these I prefer to park myself in the safest spot in the lot... the sidelines.

For related posts, check out:
The Tempest and Volatility Analysis
The Cycle of Implied Volatility

1 comment:

Stock newsletter profiles said...

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