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Just One Week To Go!

The market took a turn for the worse Friday as share values plunged on trade deficit woes. The broad S&P 500 index retreated to a previous "comfort zone" near 1200 and in light of the failed rallies above that price, many analysts are suggesting the recent upside activity may not occur again in the foreseeable future.

While that outlook certainly has merit, the multiple levels of technical support in the major equity averages should provide reasonable downside margin for any future declines and there are certainly stocks that warrant bullish positions. In addition, the widespread consolidation in stock prices should provide some favorable entry opportunities in a number of issues that had climbed to lofty levels over the past few weeks.

Of course, there is still a dearth of "premium" in options, even with the recent market gyrations, but that deficiency can be overcome to some extent through careful play selection. While that is not a particularly easy task for less experienced traders, there is merit in learning the basics of pricing theory, if for no other reason than to determine if an option is cheap or expensive.

One of the major factors affecting an option's value is the price activity (past and expected) of the underlying instrument and the most common components in this regard are historical (hv) and implied (iv) volatility. For those of you who are completely new to this subject, the volatility portion of an option's value is basically a measure of the range the underlying security is expected to change over a given period of time. This measurement is based on the standard deviation of the daily price changes in the issue. In simpler terms, the more volatile the stock, the greater the price of the option.

Historical (or statistical) volatility is based on past values and it simply reflects how far an issue has deviated from its average (mean) price, generally on a daily basis. Because a stock can be so erratic from one session to the next, moving-averages or annualized data are generally used in pricing model calculations to determine the fair value of an option. Once again, the larger the statistical volatility, the more an option will likely be worth.

In contrast, a calculation to determine implied volatility starts with the option's price and works backward to determine a theoretical value that is equal to the market price minus any intrinsic value. It is a computed number that has more to do with the option's current price, as opposed to the price of the underlying asset. The layman's definition: implied volatility is the volatility value that makes an option's fair value equal to its price in the open market.

Some traders refer to implied volatility as "premium" even though the term actually relates to the extrinsic value of an option. Since intrinsic value describes the "in-the-money" portion of an option's price, extrinsic value is simply the difference between this amount and the option's actual market price. Indeed, implied volatility and premium are related; an increase in implied volatility will raise an option's premium, as long as all the other pricing components (expiration date, underlying asset price, dividend rate, and interest rate) remain the same. The moral of the story: when implied volatility is low, options are effectively under-priced. When implied volatility is high, options are effectively overpriced.

A question frequently asked by our readers is which type of volatility (historical or implied) offers a better means of forecasting option prices. The obvious answer is that each has its advantages and limitations. Historical volatility is based on actual (past) prices, but this data may not accurately reflect the current outlook for the underlying instrument. In contrast, implied volatility indicates the "real-time" consensus of the market, thus it more accurately represents the (price) risk inherent in a particular issue. At the same time, implied volatility can be biased by supply and demand, liquidity and various intangibles such as current (sector/market) trends or future events.

Obviously, our goal is to sell options when implied volatility is high but since that condition also suggests an increased probability of an unexpected outcome, the real chore involves identifying those positions with reasonable profit potential and acceptable downside risk.

We'll talk more about this selection process in a future narrative, but now it's time to look for some candidates for the OW Portfolio.

Trade Wisely!

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