Question

Today Paul sends the following, “I really want to understand option volatility. I have looked at it from every side and have even subscribed to sites that compute volatility, but I can never figure out what to do with then number it generates. I don’t know if the number shows high, medium or low volatility. It is killing me because I know how important it is, but I can’t get a handle on it. Help!”

Answer

I’m going to keep my response very simple with the intent of writing more detailed articles in the future. Implied Volatility (IV) is the component in the price of an option that measures the probability of a large move. In general, it measures uncertainty that can originate from a few sources.

Historical price movement. If the stock has been very quiet in the past and the moves have been very gradual, the IV’s will be relatively low (like JNJ). If the stock has been all over the board the IV’s will be relatively high (like RIMM). First, I look at my expectations for the stock. If I like the stock and the price movement has been choppy in the past I will identify support and I might increase the probability of success by selling an out of the money put credit spread that is below that support (expecting it to hold). If I like a stock that grinds higher and acts in an orderly fashion I may be inclined to buy a call if the options seem reasonable. A simple test is to see how much premium a front month in-the-money (ITM) call that is at least $4 past the strike carries. Calculate the intrinsic value (stock price less strike price) and subtract it from the price of the option. If the option on a $50 stock is trading for $.30 over intrinsic value with more than 2 weeks left, that is relatively cheap. If the ITM’s are relatively inexpensive, chances are the OTM’s will be too. To get a feel, compare two stocks that trade at the same price and look at the options for each. Your strategy is dependent on your expectations for the stock.

Market movement. Most novice traders forget that 75% of all stocks follow the market. In general, when the market is falling, the uncertainty increases and so do the IV’s. Even a stock that has held up well will have increasing IV’s if the market sell off is prolonged. The overall risk level is elevated. It is more difficult for traders to predict direction (for a stock or the market) and premium sellers want more reward for taking on unlimited risk. Premium buyers are willing to pay more to limit their risk. If you have stocks that you want to own long term and you think the market lows are near, this may be a good time to sell premium. A few months ago, the market was at a multi-year high and the IV’s were at a historical low. That was a good time to be a premium buyer. Even if you bought calls, you lost money but not as much as if you had owned the stock (assuming your calls and shares were equivalent). Bring up a chart of the VIX to evaluate the overall IV environment.

News. This is the one to watch out for and avoid. It can be scheduled news or a potential event. Earnings are a scheduled. The IV’s are “juiced” to price in uncertainty. No one knows how the numbers will come out or how the market will react. A pending lawsuit, the release of clinical trial results for a new drug or take-over rumors are a few examples of potential events. In both cases, the IV’s will increase and the chart mat be relatively flat. These events are unpredictable and they make horrible trades. There are huge research firms that have models that help them determine the impact of the news and they price the options accordingly. I’m not smart enough to compete. There are many software programs that look for situations with high IV’s so that people can do “attractive” cover call writing – BEWARE. The premium is there for a reason and the most dangerous stocks are the ones with high IV’s and compressed trading ranges. It’s the calm before the storm.

In conclusion, let your expectations and confidence drive you decision to buy or sell premium. If the stock has been choppy, chances are you won’t feel as confident, the premiums will be higher and a selling strategy might work. If the stock has been on a steady trend and you feel the price movement is more predictable you might want to buy an option. Your analysis should start with the market and then drill down to the stock. The option strategy should merely reflect your opinion and confidence.

5 min read
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