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Posts Tagged ‘implied volatility’

How Option Prices are Determined

Monday, May 7th, 2012

Last week was the worst week for the market in 2012.  The S&P 500 fell by 2.4%.  We were delighted to see our 10K Bear portfolio gain 24.2% for the week (10 times the percentage loss), once again demonstrating that a properly-executed options portfolio can provide a hedge against other investments that do best when the market moves higher.

This week we will take a step back and review the components that determine the value of an option.  These components are the variables in most mathematical models designed to calculate the theoretical value that an option should be trading for, including the most popular Black-Scholes Model.

How Option Prices are Determined

Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices.  Usually, they meet somewhere in the middle and a price is determined.  This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.

There are 5 components that determine the value of an option:

1.    The price of the underlying stock

2.    The strike price of the option

3.    The time until the option expires

4.    The cost of money (interest rates less dividends, if any)

5.    The volatility of the underlying stock 

The first four components are easy to figure out.  Each can precisely be measured.  If they were the only components necessary, option pricing would be a no-brainer.  Anyone who could add and subtract could figure it out to the penny.

The fifth component – volatility – is the wild card.  It is where all the fun starts.  Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company.  Volatility is absolutely the most important (and elusive) ingredient of option prices.

Volatility is simply a measure of how much the stock fluctuates.  So shouldn’t it be easy to figure out?   It actually is easy to calculate, if you are content with looking backwards.  The amount of fluctuation in the past is called historical volatility.  It can be precisely measured, but of course it might be a little different each year.  

So historical volatility gives market professionals an idea of what the volatility number should be.  However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.

In future newsletters, we’ll continue this discussion of volatility and why it is the most important variable in option pricing.

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Posted in Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios | No Comments »

How to Contend With Historically Low Option Prices

Monday, March 19th, 2012

Option prices for the market in general (SPY) are lower than they have been for five years.  Maybe it is time to change from a strategy of selling short-term options (the strategy carried out at Terry’s Tips) to one of buying those options and hoping the market is more volatile than those low option prices would expect.

We will discuss that possibility today.

How to Contend With Historically Low Option Prices

Before discussing the situation of low option prices for most equities, I should comment on the continuing high option prices for Apple.  Implied Volatility (IV – the most important determinate of whether option prices are “high” or “low”) is about 40 for AAPL.  This means the market is expecting AAPL to fluctuate about 40% over the course of a year.

The high option prices for AAPL has meant that our calendar spread strategies has been quite successful of late (we move our calendar spreads to new strike prices as the stock moves higher).  We carry out two AAPL portfolios at Terry’s Tips – one gained 8% last week and the other gained over 20%.  The one that gained 8% has been operating for one month less than two years and is now ahead by 642%.  It is our most profitable portfolio by a large margin. 

Compare this 40 IV number for AAPL to IV of the S&P 500 tracking stock, SPY, which is called VIX.  It is less than 15, and briefly fell below 14 last week for the first time since I can remember.  This is extreme low territory (the mean average is about 20).

The IV picture for SPY gets even more interesting when you check out the Weekly options.  When VIX is calculated, the Weekly option prices are not included (only options with 8 or more days of remaining life or included).  IV for the SPY Weeklys is only 12.47.

Last week SPY rose $2.70 and the week before, moved by $3 in both directions during the week.  If you bought an at-the-money straddle or strangle using SPY Weeklys at today’s prices in either of those weeks, you would surely have doubled your money in a single week.

With SPY closing at $140.30 last Friday, you could have bought a 140 Weekly straddle (both a put and call at the 140 strike) for $1.80 or a strangle (the 141 call and the 140 put) for $1.33.  If the stock moved by at least $1.50 in either direction next week, either of those purchases should result in a gain.  SPY moves by that much in just about every week, even in quiet markets like we have been having so far this year.

_ _ _

It is an interesting trade to try.  I plan to buy a few this week (in both my personal account and in one of the Terry’s Tips portfolios), just to test it out.  Of course, you should never risk money that you can’t afford to lose.

We have made 3 short videos which explain the 3-week results of our AAPL trading. The original positions were set out in an actual account carried out at Terry’s Tips.  The YouTube link is http://youtu.be/6J9KPuimyXk

The portfolio was updated in the Week 2 video -
http://youtu.be/e0B7_6e_5AE 

And finally, adjustment trades we made were displayed in this little video –
http://youtu.be/YC3d2NuX2MI  Be sure to enlarge it to full-screen mode so you can see the numbers. 
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Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.

You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips (including the two AAPL-based portfolios) and learn all about the wonderful world of options by subscribing here.   Why wait any longer to make this important investment in yourself? 

I look forward to having you on board, and to prospering with you.

Terry

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Posted in AAPL, SPY, Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios, Weekly Options | No Comments »

Choose an Option Strategy Based on Actual vs. Implied Volatility

Monday, October 31st, 2011

It is important to differentiate between the implied volatility of option prices and the actual volatility of the underlying stock or ETF.  It is not an easy task to recognize when the two measures deviate from one another, but if you can identify a difference, huge gains can be made with the proper option strategy.

Today we will discuss how you can capitalize on any differences that you might be able to find.

Choose an Option Strategy Based on Actual vs. Implied Volatility: 

 
Last week the European debt crisis was apparently averted, at least in the eyes of option investors.  VIX, the so-called “fear index”, the average implied volatility of option prices on the S&P 500 tracking stock (SPY) fell dramatically to just below 25 (still above its mean average of about 20 but well below the 40+ it has sometimes been at during the previous month).

When option prices are high (i.e., implied volatility, VIX) is high, there are huge gains possible by writing call options (not our favorite ploy) or buying calendar spreads (our favorite most of the time).  However, when actual market volatility is greater than the expected volatility (i.e., implied volatility of the option prices), writing calls or buying calendar spreads is generally unprofitable.

Over the last three months, we have had great difficulty making gains with our calendar spreads because actual market volatility was too great.  On the other hand, we have had some luck with buying straddles (or strangles), a strategy of buying both a put and a call on the same underlying and hoping that there is a big fluctuation in either direction.

Last Wednesday, after following VXX (a “stock” that is based on the futures of VIX), we noticed that actual volatility was huge – it had fluctuated $2 or more almost every single day for several weeks.  On Wednesday in one of our portfolios we made a small ($1400) buy of 5 VXX 43 puts and calls which would expire two days later.  We paid $279 per straddle.  When the market for VXX opened up sharply lower on Thursday, we sold the straddle for $596, netting 117% after commissions.

In another portfolio where we owned calendar spreads on VXX, we lost money.  Our results in these two portfolios clearly demonstrated that when high actual volatility occurs, you do best by buying short-term options, either puts or calls depending on which way you believe the market is headed, or both puts and calls if you admit you really don’t know which way it will go (as we usually do).  On the other hand, when actual volatility is low, calendar spreads deliver higher returns.
Now that much of the uncertainty facing the market has subsided a bit, we believe it is time for the calendar spreads to prosper once again as they have for most of the past few years (since late 2008 extending up to August of this year).

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Posted in SPY, Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios, VXX | No Comments »

Finding an Implied Volatility Advantage

Monday, August 15th, 2011

This market has surely been a crazy one. It has been a difficult one for many of our portfolios that do best if the market is flat rather than gyrating all over the place. But right now, option prices are such that new spreads promise to do exceptionally well, especially if the market manages to settle down a bit.

Today I would like to discuss an important feature of buying calendar (or diagonal) spreads.

Finding an Implied Volatility Advantage

 

When market professionals talk about the Implied Volatility (IV) of a particular stock or ETF, they are referring to the at-the-money current-month put and call options for that underlying instrument.

While it makes total sense that every option for a particular underlying should have the same IV, in reality it is usually not the case.  Some options are more expensive than they “should” be and others may be cheaper than they “should” be.

When I was a market maker on the CBOE, one of my favorite tactics was to find discrepancies in IVs of options on the same underlying, selling the “over-priced” options and buying the “under-priced” options.  I would try to maintain a neutral net delta condition at all times so I didn’t care whether the stock went up or down while I waited for the market to correct itself and move the IVs of both sets of options closer to parity.   (I surely wasn’t alone in using this tactic, as it was, and still is, one of the most widely-employed strategies on the floor.)

The 10K Strategy that we carry out at Terry’s Tips involves buying LEAPS (or other longer-term options) and selling short-term options (sometimes Weeklys) against them.  If the long and short sides of the spread are at the same strike, it is called a calendar spread, while if they are at different strike prices, it is a diagonal spread.

In the best of all possible worlds, we would seek out underlying stocks where the LEAPS carried a lower IV (so they were “cheaper”) than the IV of the short-term options (which were more “expensive”).  Whenever we enjoyed this difference in IVs, we know that we have an IV Advantage.
   
Most of the portfolios that we carry out at Terry’s Tips use SPY as the underlying, in spite of the fact that there rarely is an IV Advantage for that ETF.  It is more likely to be found for individual company options, especially when there is a rumor or earnings announcement coming soon, as short-term options often see unusually high IVs in anticipation of such events.

At the present time, the short-term options for SPY carry a higher IV than do longer-term options.   The August options that expire this Friday carry an IV of 36 while SPY options expiring in January 2013 have an IV of only 28.  This would be a perfect time to place the kind of calendar spreads that are the basis of our most popular strategy.

While having an IV Advantage stacks the deck in your favor, it should not be used as a sole determinate in choosing an underlying instrument to trade options on.  It is possible to make good returns with the 10K Strategy when you don’t enjoy an IV Advantage, but it is extremely helpful whenever option prices make it possible.    

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Posted in 10K Strategies, SPY, Stock Option Trading Idea Of The Week, Stock Options Strategies, Terry's Tips Portfolios, Weekly Options | No Comments »

How to Trade Rumors of Takeovers

Thursday, July 7th, 2011

Sometimes someone else says it as well as I think I can.  Today I would like to pass on what Steve Sears at Barrons.com wrote about trading on rumors of a takeover.  I agree with him completely.  Bottom line, I believe the answer is to do nothing about them.

“Everyone loves the idea of owning a stock, especially call options, on a company that might be taken over at a hefty premium. But the options market inflates with at least 10 false takeover rumors for every real deal. Individual investors need to be careful to avoid getting fleeced for reasons that have far more to do with market realities than risk-aversion.

The best bet for most investors is ignoring takeover rumors. If you own options on a takeover stock, sell them, and book the profits. How much better can it get? When rumors become facts, or fail to become facts, implied volatility declines.

If you must trade takeover rumors, buy inexpensive out-of-the-money calls that expire in three months or less. If the deal emerges, you’ll make money, and not lose much if nothing happens.

To be sure, institutional investors who own dud stocks, or who want to create profits where none exist, spread rumors to drive options and stock prices higher to attract unsophisticated investors.

The game works like this: traders buy enough out-of-the-money call options to be spotted by unusual-trading volume screens that monitor the options markets. Inevitably, a reporter, or one of the market-trading subscription Websites notes the unusual trading, and deal speculation sweeps the market. Takeover talk attracts greedy investors who pay top prices for call options, which creates selling opportunities for those who started the rumor.

No one has statistics on how many takeover rumors fail to materialize, but when you feel eager to get a piece of the action, think of the rows of grizzled gamblers hunched over Las Vegas slot machines. They have no special knowledge. They have no special skills. They just hope to get lucky. The same rubric applies to most takeover traders.

“Losers,” as seasoned traders like to say, “always come back to Vegas.”

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Posted in Stock Option Trading Idea Of The Week, Stock Options Strategies | No Comments »

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I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.

~ John Collins