We just completed another expiration month when volatility was higher than historical standards. Such an environment has made it difficult for our calendar spread strategies to work as well as they do when volatility is less. Today we will discuss the important distinction between Implied Volatility (IV) and Historical Volatility (HV).
Implied Volatility Vs. Historical Volatility
It is important to understand the difference between Implied Volatility (IV) which is a market estimate of underlying price fluctuation and Historical Volatility (HV) which can be precisely measured.
Using the Black-Scholes model or any comparable option-pricing model, if you know the price of an option (as well as the measurable variables such as stock price, time to expiration, etc.), you can easily calculate the IV of each option.
If you compare the current IV of an underlying’s options with its HV, you can determine if today’s option prices are “higher” or “lower” than what they historically have been.
As a general rule, it is best to purchase options when IV is lower than HV and sell options when IV is greater than HV. The two numbers tend to eventually move to be the same.
The absolute best time to buy options is when IV is low compared to HV and you expect the market will become more uncertain in the future so that IV escalates (and option prices go up in value).
One of the ultimate determinates of the success of the 10K Strategy is the relationship between the IV of the options we trade and the eventual actual volatility that the underlying stock or ETF displays. If actual volatility is less than IV, we almost always win big time, and when actual volatility is greater than the IV of the options we trade, making gains is more of a challenge.
Of course, over time, IV tends to move up and down with actual volatility, just as IV tends to move toward HV. If a stock becomes more volatile over time, the market expects that it will continue to be more volatile in the future, and IVs of the options tend to go up.
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.
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Terry
Last week I stated the following “As I stated back in early May, my guess is that we will continue to stay within a range during the summer doldrums. Now that we are back towards the bottom part of the range with the major market benchmarks in an oversold state I would expect to see a nice bounce coming our way over the next week or so."
Okay, so the bounce came this past week as expected. The oversold to very oversold state that the market had entered while simultaneously hitting the bottom of the summer range and the 200-day moving average has me encouraged going forward. Yes, we are currently in an overbought to very overbought state, but this is a short-term state (1-3 days). I do expect to see this play out as usual with a short-term decline as we enter the early part of next week, but once the major benchmarks move back into a neutral state I will be watching closely to see how the market reacts.
The S&P (SPY) has already successfully tested the 200-day MA twice and if it can now move through the next level of overhead resistance at roughly $96 we could see a really nice advance as we head into the latter part of 2009. If the S&P (SPY) is unable to break through this level of overhead resistance then I expect to see a continuation of the range-bound movement that we have seen since early May. "I think it's very constructive that we're taking a pause here and not heading back down," said Richard Sparks, senior equities analyst at Schaeffer's Investment Research.
The advance this week can be attributed to solid bank earnings, improving economic data and upbeat forecasts from the tech sector. As a result, the weeklong surge left the market roughly 7% higher when all was said and done Friday afternoon.
"The important thing is these earnings results, while not all entirely positive, are beginning to show some signs of stabilization," said Tom Kersting, an analyst at Edward Jones.
"The earnings are better than expected and the economic news is not horrifically bad," said Jeff Buetow, managing partner at Innealta Portfolio Advisors. "I think people want the market to go up."
Yes, the economic news was better than expected. Inflation readings were higher than expected according to the PPI and CPI reports but this was largely due to the recent rise in energy prices. The core rate of the CPI was still well within the Fed’s comfort zone. More importantly, the recent concern of deflation was quelled, at least for now.
Industrial production was down for the 17th month out the last 18 months. However, the decline was the smallest since last July which could be a sign of better things to come at least that was the spin that the market put on it this past week. Initial claims fell for the second straight week and continuing claims fell by 624,000 which was the largest drop ever reported. The poor report didn’t matter this week as the bulls had the reigns and had no intention of giving them up.
As I stated above, the market has pushed into a short-term overbought to very overbought state. Typically, this means that we should see a short-term decline over the next few trading sessions. Moreover, the trading day following option expiration is historically weak so this just another reason for my short-term bearish slant. However, once we move back into a neutral state it is anyone’s game again and I expect to see the bulls come back fighting. One thing is certain, we will see soon enough.
Overbought/Oversold as of July 17, 2009