Option Investor
Educational Article

Getting Back To Basics

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By: Lee Lowell

Let's go over a few issues that seem to be confusing some of our readers. Before you ever dive into the market and buy or sell an option, you must do a little preparation. If there is no analysis involved, you will get eaten alive. First, you must have access to an option calculator. Most likely it will be a calculator based on the Black-Scholes equation. I suggest going to the CBOE website and clicking on their "Trader's Tools" link. Within the Tools, click on the "Option Calculator". This is your first step in getting a handle on how the option is priced in the marketplace. All the inputs that are necessary for the option calculator are readily available, except the volatility component. The volatility component is something that we've discussed extensively, but there still seems to be some confusion.

Any option calculator will ask you for your volatility "estimate" of the underlying stock. The volatility estimate is what you think the volatility of the underlying stock will be until your option expires. You need to make an educated guess on this volatility. In order to make a guess, you should look at the stock's "historical" volatility behavior. I've had many questions on where to look for this historical volatility. There are not many free places on the web to find these statistics except for the CBOE website. Within the tools section again, you can click on the "stock's historical volatility" link. At this point you can get a handle on how the stock has moved in the past. I believe the CBOE breaks down the HV into 30 day intervals.

Once you've seen the past results, you make your own guess of volatility and plug it into the option calculator. This is called your "forecast" volatility. Whether your forecast is right or wrong is yet to be seen. But at least you've done some analysis.

The next step is to check your option's "implied volatility". This is the volatility component of the option itself and it signifies what the market participants predict for the underlying stock in the near future. It's almost like saying the option itself is making a prediction of the stock's movement. Remember, volatility (historical or implied) is a number that gives you an idea of how the underlying has performed in the past and how it hopes to perform in the future. You can also use the option calculator to figure out any option's implied volatility. Just plug in all the variables excluding your volatility guess, but including the option's price as it's trading in the market. Since you've swapped your volatility guess for the option's price, the calculator will now spit out for you a volatility number instead of a theoretical value. This new volatility number is the option's "implied volatility".

So you now have your "forecast volatility" which is derived from looking at how the stock has fluctuated in the past. And you have the option's "implied volatility". It's you against them! How do the two compare? Is your FV higher/lower than the IV? If there is a significant difference, then you must dig a little deeper or check your analysis. If the IV is much higher, then there is probably some excitement surrounding the stock because of takeover rumors or earnings announcements approaching. If you are confident with your volatility forecast and it differs significantly from the option's IV, then go ahead and take advantage of the situation by buying or selling options based on the FV/IV relationship.

What really helps in getting an idea of how the stock and option's volatility has moved in the past is to look at historical charts of each. I believe that looking at past IV charts is essential when trading options. Unfortunately, this is not easy to find on the web anywhere for free either. The options broker that I use for my own trading has their own in-house volatility charts that comes in pretty handy. That is mrstock.com. Check 'em out. I've also been asked to suggest datafeed vendors that supply IV and delta information. Take a look at esignal.com, dtniq.com, interquote.com, pcquote.com and mt98.com. I believe all of these have IV columns in their options chains, and mt98 & pcquote even have "bid IV" and "ask IV" columns too which is a big plus. MT98 might even have IV charts too.

In my opinion, IV is a much more important number to focus on than the HV. The HV just tells me the price band that the stock has moved within over the past. Over time, all stocks will develop an average volatility level that the stock seems to revert to. If it's trading above its mean, it will eventually move back down to it. And if it's trading below the mean volatility, it will eventually trend back up to that level. Fine. But if you want to trade the options, you're gonna be trading them based on IV. You get a quote for a certain option from your broker, and that option has an IV attached to it. You buy or sell that option based on its IV. Not only can the IV be higher or lower than the HV, but the IV can be high or low compared to its own past. Here's an example. We want to analyze a 3-month IBM ATM option. IBM has a 90-day historical volatility of 35%. The ATM option has a 1-day IV of 40%. This is obviously above the HV. But is the IV high/low compared to its own past? For the last 90 days, the IV has ranged from 40% - 80%. So the 1 day IV of 40% is low for its range but still higher than the HV. What's the assessment? It seems that over the past 3 months, there was pumped up excitement in the options for whatever reason. But as rumors were quelled, the option's IV started to come back down in line with the HV. As I've said previously, the HV and the IV usually move in tandem except for those few occasions. We know that the IV for IBM ATM options are close to the HV now but at the low end of its IV range. At this point you can say that IBM options are fairly priced. If the 1 day IV had been 80% instead of 40%, it would be fair to say that IBM options are relatively expensive, so selling strategies could be in your future.

This is what volatility analysis can do for you. The datafeed vendors I mentioned can get you started in the right direction. Last week I mentioned that another author stressed in his book that too many traders only focus on their timing techniques when trading options. Once they predict which way the stock will move in the future, they indiscriminately purchase any option they can get their hands on. This is a BIG mistake. They may be right about the direction, but they may be buying grossly overvalued options. Going back to our IBM example above, what if this trader had bought IBM options when the IV was at 80%? He/she would surely lose over the near term as the IV plummets down to 40%. Or if he/she happened to be lucky enough to squeak out a gain on the trade, it's not nearly as much as he/she would've made if the options had been bought at 40% IV. The strategy of this trader should've focused on selling options to take advantage of the IV. If he/she was bullish on IBM, then selling puts, put spreads, or writing covered calls would be the optimum strategy.

I believe I have exhausted the subject of volatility over the last few weeks. For any newcomers to OIN, just click on the "Options 101" link in the left-hand margin and read some of the previous articles. There' some good information on volatility in general, along with ways to use it in your own trading. You can use volatility analysis to give yourself an advantage when putting on call and put spreads, ratio spreads, straddles, etc. Don't forget to look at the formula I previously presented to give yourself an idea of the stock's possible range until expiration date. It's just another tool to help you make a more informed trading decision.

Good Luck.

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