What A Great Weekend!
I'm writing this week's article as I'm flying back from the Denver expo. Right now I'm somewhere over the Pacific Ocean on my way back to Hawaii. Before I actually made my decision to attend the seminar, I was a little hesitant on whether I should go or not. I was given an invitation about 5 weeks before the event and I wasn't really sure if that was enough time for me to put together a quality presentation. Let me just tell you, even though I had concerns, attending the expo was probably the best decision I've made in a long time. I don't care how much you think you might know about stock and option trading, there's always someone else out there who knows more than you and there's always something you can learn at any point in your life. And I'm glad I went because I learned a bunch.
Anyways, I'd just like to say that I was honored to be a part of such a wonderful event. The list was long on quality speakers and the food was great too! I enjoyed talking to many of the attendees and it was great to finally put a face to the names of all my OIN cohorts. As some of us writers are freelance, we all don't get to work together in the Denver office. I got a real kick out of listening to Chris V's horror trading stories, and I feel the rest of the gang are all top notch. It was great to meet Jim, Buzz, Vince, Mark, Molly, and Austin (and Wendy too!) So thanks again everyone for letting me share with you what I know about options trading.
Just before I was about to give my presentation at the expo, the Head Guy - Jim Brown, said that my topic of discussion is a boring subject, so there may be some sleepy faces out there. The nerve! What's boring to some may be fascinating to others. At least that's what I was told afterwards by a few wonderful attendees. Nevertheless, when I was finished giving my presentation, I came to the conclusion that many of the students don't do much in the way of volatility analysis before they actually put on a trade. But that's okay, because that's why they came to the seminar in the first place. For some of you who didn't attend the expo, my topic of discussion was volatility and how to use it in your trading. I realize that my topic was not on the high priority list for many of the students. The feeling that I get now is that most of the readers want to know what trade to make, when to make it, and when to get out. That's what the subscription is for. The picks are well researched and the reader knows they are quality plays recommended by qualified professionals. Nevertheless, through all my years of trading, I've learned that there can only truly be one person who should be the ultimate decision maker and who should hold sole responsibility for their trades. And that one person is YOU! (or me in this case). So even though you have faith in the OIN picks, just make sure you go the extra step and do a little more research.
And this is where I come in. There was a ton of information packed into those 3 days for even the most veteran traders to absorb all at one time. This is why I'd like to dedicate the rest of my article to going over the key points that I was trying to convey in my presentation.
Since my topic was about volatility, we need to distinguish between the 2 different types. Historical volatility (HV) is a measurement of the past price behavior of the individual stock or index. It can be measured for any period in the past that you wish to study. It is quoted as a % number like 35% for example. It tells how the prices of the stock have been distributed over time. In statistical terms, the volatility is really the standard deviation of those price changes. Looking at the past HV of a stock can give us a clue as to what the stock's volatility might be in the future. Thus, giving us a clue of what kind of range the stock might fluctuate within until our options expire.
Implied volatility (IV) on the other hand, is a % number that is unique to each individual option that trades on that underlying stock. IV is the option market's best guess as to what the stock will do in the future. So in essence, the options are giving us a clue about future movement of the stock. HV is based on past price behavior, and IV is based on future expectations. Which one is correct? That's the mystery and that's what makes options trading so unique. You'll never know which one is correct until your options actually expire and you can go back and see which one was more accurate.
How do you use HV and IV? They are used to assess the relative expensiveness or cheapness of option premiums. In my personal trading, I will use IV data 95% of the time to tell me whether option premiums are high or low. The way to do this is to check past levels of IV by using historical IV charts. Just as some stocks seems to trade within certain price ranges, IV can do the same. If IV is in the high end of its historical range (I like to look at 2 years worth of IV history), then I know option premiums are on the high side and I should look for selling strategies. If IV is on the low end of its historical range, then I will look at buying strategies. And those buying strategies don't always entail the buying of calls. I can look to buy puts also. I choose to focus on the past behavior of IV instead of the past behavior of HV because I like to look at future expectations and not on what happened to the stock in the past. The traders on the options exchanges are the ones who set IV and I'm going to accept their levels. They are the ones with the most information and the most experience(most of the time), so I'm not going to argue with their levels. Why try to fight the market? Just like I said at the expo: If you want to buy a YHOO $60 call and get a quote of $15 for that call, do you have any idea if that's a fair price for that $60 call? Maybe it should be worth $13 or maybe it should be worth $17. The only way to truly know is to check the IV. If IV is high, then that $60 call is probably overpriced. If IV is low, then maybe $15 is a good deal. Check the volatility.
The next step is to use an options calculator. These are free handy little tools that you can use to price any option. It can figure a stock's HV and any option's IV. The calculator can also be used for "what-if" situations. Just change around the price of the stock, change the days-to-expiration, or change the volatility estimate and you will see how the price of your option will change.
Once you've seen what your option should be worth and what you feel may happen in the future, take your break-even points and throw them into a probability calculator. The probability calculator, which can also be gotten for free on the web will give you your true odds of success. Just plug in your break-even or stop-loss levels and the probability calculator will tell you what your chances of success are. You'll be amazed at the results. If you are solely an option's buyer, you might be a little disappointed at the low odds of success that most option- buying strategies provide.
Lastly, I'd like to go over an option "skew." Skewing occurs when each option on the same stock trades at a different IV level. This will occur because of the fears and speculations of the individual option players. Some think they can beat the market and play the market accordingly. Others get irrational because of fear of loss and will trade accordingly. When you get those emotions factored into the market, it causes discrepancies in the option prices and thus leads to different IV on each strike. We can take advantage of skewing by doing spread trades. They can be debit spreads, credit spreads, ratio spreads, backspreads, etc. If you can construct the spread whereas you buy the lower IV strike and sell the higher IV strike, you will theoretically have a position with an edge. Take a look at some of my older articles that go into details on how to use these strategies.
Good luck and use all the tools available. Happy Halloween!