Stock Option Trading Idea of the Week
Understanding Volatility - Part 1
Volatility is the sole variable that can only be measured after the option prices are known. All the other variables have precise mathematical measurements, but volatility has an essentially emotional component that defies easy understanding. If option trading were a poker game, volatility would be the wild card.
Volatility is the most exciting measure of stock options. Quite simply, option volatility means how much you expect the stock to vary in price. The term "volatility" is a little confusing because it may refer to historical volatility (how much the company stock actually fluctuated in the past) or implied volatility (how much the market expects the stock will fluctuate in the future).
When an options trader says "IBM's at 24%" he is referring to the implied volatility of the front-month at-the-money puts and calls. Some people use the term "projected volatility" rather than "implied volatility." They mean the same thing.
A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number. For P & G, this number currently is 20%. That is how much the market expects the stock might vary in price, either up or down, over the course of a year.
Here are some volatility numbers for other popular companies:
- IBM - 24%
- Apple Computer - 31%
- GE - 43%
- BP - 60%
You can see that the degree of stability of the company is reflected in its volatility number. IBM has been around forever and is a large company that is not expected to fluctuate in price very much, while Apple Computer has exciting new products that might be great successes (or flops) which cause might wide swings in the stock price as news reports or rumors are circulated. GE is relatively high right now because of its involvement in the financial arena where uncertainty is high. Of course, BP Oil has even more uncertainty.
Volatility numbers are typically much lower for Exchange Traded Funds (ETFs) than for individual stocks. Since ETFs are made up of many companies, good (or bad) news about a single company will usually not significantly affect the entire batch of companies in the index.
Here are some volatility numbers for the options of some popular ETFs:
- Dow Jones Industrial (Tracking Stock - DIA) - 23%
- S&P 500 (Tracking Stock - SPY) - 24%
- Nasdaq (Tracking Stock - QQQQ) - 26%
- Russell 2000 (Small Cap - IWM) - 35%
Since all the input variables that determine an option price in the Black-Scholes model (strike price, stock price, time to expiration, interest and dividend rates) can be measured precisely, only volatility is the wild card. It is the most important variable of all.
If implied volatility is high, the option prices are high. If expectations of fluctuation in the company stock are low, implied volatility and option prices are low.
Of course, since only historical volatility can be measured with certainty, and no one knows for sure what the stock will do in the future, implied volatility is where all the fun starts and ends in the option trading game.
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 exactly how we made 13% after commissions last week in 5 actual SPY option portfolios conducted at Terry's Tips 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
Andy's Market Report
It was another volatile week for the U.S. markets. The bulls tried valiantly to push the market higher and actually managed to do so for the first three days of the week, but the 1100 level on the S&P proved to be too difficult an area of overhead resistance for those who currently lean with Taurus.
Furthermore, the post FOMC sell-off that began with a gap lower on 8/11 has yet to see that gap fill at the $111.37 on the S&P 500 (SPY). However, the broad market is currently in a short-term oversold state so I do expect to see a short-term bounce, but I think we could see lower prices, potentially a test of the early July lows, before a significant bounce occurs that fills the gap from 8/11.
Economic data has also been a culprit in the waning support from the bullish camp. Just this past week, initial claims came in for the week ended August 14th at 500,000, which was well above economists' expectations. Secondly, the Philadelphia Fed business outlook survey came in far weaker than expected at -7.7, Economists; had predicated almost the exact opposite at 7.5.
Quite honestly, the week could have ended much lower, but the bulls and bears are currently fighting within the range-bound of 1070 and 1100 and until one of those levels is broken with a sustainable move then I expect to see more of the same until the summer doldrums come to a close. One thing that is currently in the minds of Wall Street traders (at least a few anyway) is the latest hype surrounding the Hindenburg Omen. For those of you who are not familiar with the technical analysis pattern the Hindenburg Omen is said to portend a stock market crash.
The arcane, data-mined technical analysis signal that for some reason the major news networks/publications and basic cable stations picked up on this past week certainly piqued my interest as well.
I truly wanted to see just how effective the signal actually was on a historical basis and here it what I found.
From historical data, the probability of a decline that exceeds 5% after a confirmed Hindenburg Omen signal was 77% and typically would take place within the next forty trading days. The probability of a major stock crash was only 24%.
However, many technical analysts have suggested that the Hindenburg Omen is not truly effective until a second signal is confirmed within two weeks of the first.
So, after even more investigation let's see what the S&P's performance was after a second signal was confirmed within two weeks of the first. Fortunately, my research became that much easier after I came across this chart from Jason Goepfert of www.sentimentrader.com.
As you can see the signals were most effective at pointing out the high-risk events in the market. There were only three occurrences when the broad market index, S&P 500 actually witnessed an advance three months later and the risk/reward leaned heavily towards the bears.
The average numbers of days that the S&P took to bottom was 40 and there was only one occurrence when the broad market index bottomed immediately. One thing is for certain, there has not been a huge move out of stocks because of it. Many feel as though the signal has been tweaked and data-mined to make it more effective, but that is still up for debate.
As I stated before, I do think that with earnings season over and the market currently digesting some weak economic news that we could get another retest of the early July lows. If we do happen to make it to those levels, I will once again try and evaluate the market to see if the probability of a further move to the downside is likely.
As we look forward to next week, all eyes are focused, once again, on the economic calendar. Tuesday is existing home sales, durable goods will announce on Wednesday and initial jobless claims on Thursday. Moreover, a second reading for the Q2 GDP will come out on Friday.
I expect to see more fireworks now that options expiration has passed. Again, I do expect a short-term bounce and then most likely a decline late into next week.
Andy
Overbought/Sold Condition Report
Overbought/Oversold as of August 20, 2010
- S&P 500 (SPY) - 26.6 (oversold)
- Dow Jones (DIA) - 23.5 (oversold)
- Russell 2000 (IWM) - 31.3 (neutral)
- NASDAQ 100 (QQQQ) - 36.1 (neutral)
Testimonial of the week
I can't figure out why everyone isn't using calendar spreads using your method. Sometimes it seems too good to be true. My returns the past two years have been almost unbelievable. I don't even try to tell anyone about it because they wouldn't believe me. - Fred R