A report from Reuters helped propel biotechnology company ^BCRX^ over 5% during trade on Monday. The report indicated that researchers concluded that the virus that causes the Swine Flu builds up a resistance to antibiotics very quickly. This news propelled BCRX throughout most of the day and extremely high volumes of calls traded hands.
April 7.50 call options on BCRX have an open interest of 2,117 contracts and nearly 2,000 contracts had changed hands during the trading day. The surge in the share price also coincided with a massive boost to implied volatility to BCRX option premiums. The May 7.00 call options have an open interest of 1,990 contracts and Monday nearly 900 contracts traded hands. The implied volatility on the May options went from 46 on Friday to 58 today.
Inquiring minds might wonder what types of option trading setups would make sense in a situation like this. For many beginners or novice option traders, their first instinct would likely be to sell option premium with the intent to make money on time decay. At first glance, selling option premium makes sense, but an option trader must be mindful that volatility could continue to increase. Should volatility continue to increase, an option trader that sold premium too soon could suffer from losses. Option traders should also note that when trading small cap biotechnology names, price fluctuations can be fast and dramatic making entry difficult and potentially quite risky.
The alternative to selling options premium would be to purchase options (in this case, perhaps calls). Though, to be sure, this strategy also involves a significant amount of risk in this situation. Option traders need to focus on risk management as poorly timed trades in relation to volatility can ruin returns, even when price action is favorable. Option traders must respect volatility at all times, and see both sides of the trade.
Many novice traders are not aware that sometimes not trading can, in fact, be a great strategy. In this type of situation, being patient is likely the best course of action. Instead of entering into a high-risk position, it could instead be beneficial to continue to monitor the price action and the volatility of BCRX, but not trade. There is not a sound risk-reward to selling or buying options premium, and even though price and volatility have increased dramatically, sitting on the sidelines might be the best answer.
Option traders should be cognizant of a basic poker principle: “You can’t lose what you don’t put in the middle.” Just like in poker, sometimes no trade is the best trade. The key to all forms of securities trading is to manage risk and enter trades that have a high probability of success. An option trader that ignores volatility, risk, and profit probability is trading blind. An option trader that ignores volatility entirely will notice volatility in their trading account, and the volatility will likely exacerbate to the downside.
Dan Passarelli is the author of the book Trading Option Greeks and founder and CEO of Market Taker Mentoring LLC. Passarelli began his trading career trading on the floors of the Chicago Board Options Exchange and the Chicago Board of Trade making markets in options. He regularly shares trading insights and educational tips in his options blog (markettaker.com/options_blog/). Dan can be reached through his website MarketTaker.com and can also be followed on Twitter at twitter.com/Dan_Passarelli.