What to do with the collapse of implied volatility in stocks like AIG

As can be seen in the decline of the VIX throughout 2009, implied volatility as a whole has declined significantly.  The most recent decline pushed the VIX periodically below the 20 level (please note a lot of this had to do with the holidays).  In practice this means that the premiums paid or collected for stocks have gone down as a whole.   With the decline in the actual volatility of the market this makes sense.

However, if there are names you follow that you feel could have large moves over the first half of the year, you may want to think about things like long options or debit spreads using out of the money options.  Why?  Well, if the premiums you pay are lower for these spreads, then your break-evens are actually better.  I looked at AIG as an example of this. 

AIG was one of the most volatile stocks of 2009.  Its 52 week range is $6.6-$55.9, and now it is trading at $30.  Implied volatility is down about 50-75% from its peak.  This is a stock that has huge leverage because of the amount of debt it is paying back the government .

If you think this stock will not have any value after its asset sales, the May 20 puts are trading at $1.25.  I know that is 50% out of the money, but this is a leveraged stock.  Let me show you how much cheaper these are than they would have been 6 months ago when volatility was higher.  If the implied volatility of these doubled (which is where implied volatility was), these options would be worth about $4.75 with the stock in the same place!  That is a 280% increase with no movement down in the stock.  

If you think the stock is going to make another run at its highs, the May 35-50 call spread is only trading about $1.8, and it has a maximum value of $15.  If volatility doubled, the spread would be worth about $2.4, without any move in the stock.  That is an increase of 33%.  While that pales in comparison to the outright puts, it is a huge move for a spread that does not have that much vega.

I presented one example to the upside and one to the downside because I am not making a recommendation on AIG.  If the stock just sits at $30, these strategies will lose eventually because of time decay.  This was an example of how much lower options premiums are, and how traders should at least look at these factors when picking a strategy to employ.  As always, the trader needs to pick the right direction of the stock and time of the move (or lack of move) to be profitable.