For traders new to options, the pricing of the options is often times misunderstood. While there are many different ways of trading options, the Trend Jumper gives us a great tool to trade them directionally. When trading options, we need to first consider 3 variables about the specific stock in play:
1. The expected price direction
2. How long we think the move will take
3. The stock’s future volatility
The Trend Jumper will give us an endless number of possible stocks to trade, which allows us to focus on picking the correct options to play that stock with. Most inexperienced options traders will pick the cheapest option possible to try and capture the large percentage return that comes with a home run trade. They don’t understand that the most dominant factor in the pricing of options is volatility. Options are priced with the following factors in mind: stock price, strike price, time, interest rates, dividends, and volatility. All of these factors regarding option pricing are fixed except for volatility. Trading options without an understanding of how important a role volatility plays in their pricing, is one of the main reasons so many options traders struggle to find the desired results.
There are two types of volatility that are important to the discussion of options trading:
1. The first is historical volatility, which is a measure of how fast a stock has been moving when looking back at a given amount of time.
2. The second type of volatility that is important for options traders to understand is implied volatility. Implied volatility is an attempt by traders and market makers to assess the future volatility of the stock.
Volatility can be affected by situations such as an earnings announcement, a takeover bid, a sudden change in company leadership, or a government report to name a few.
Volatility will be displayed as a percentage. The percentage is used to determine the expected range of the stock over a year. For example, if XYZ stock is trading for $60 with a 20% volatility, then that stock is expected to trade between $48 and $72 over the following year. Volatility will change on a daily basis, which makes it the most important factor when deciding which strategy to put into play.
This is why I like to be familiar with the stocks that I trade on a regular basis. I need to be familiar with the levels of volatility so I can choose the correct option to play. Since implied volatility is just an attempt by traders to measure the volatility going forward and is the only unknown factor in the pricing of the option, it is up to us to determine if that level is high or low. The implied volatility listed on your broker’s platform will be the percentage that is being used in the pricing model to give the current price of the option.
Volatility will always go back to its historical levels at some stage in the future. With this in mind, if we determine that volatility is high, we could look into strategies that involve selling options.
This would allow us to take advantage of the higher prices of the options, with the expectation of volatility falling back to normal levels. In periods of low volatility, we may decide to be buyers of options to take advantage of the cheaper prices, with the expectation of volatility going back to normal higher levels in the future.
Let’s take a look at a recent example to see the affects of changes in volatility in the pricing of the option. Google released their earnings after the close on Thursday July 16. With Google trading at $442 just before the close of the equity session, a trader that was anticipating a bad reaction to the earnings could have purchased the August 440 put, which happened to be the atthe- money option. The earnings were released after the market close and the reaction was negative just as expected. The following table summarizes the result of this trade.
Google Earnings Play 7/16/09
Stock Price 7/16: $442.60 Stock Price 7/17: $430.25 -12.35
Implied Volatility: 36% Implied Volatility: 27%
440 Put: $17.50 440 Put: $19.20 +1.70
The Stock moved as anticipated, but the option only increased in value
by $1.70 while the stock tanked by over $12.00. Implied volatility
dropped back to 27% on Friday which meant the trader was right in
his opinion of the stock move, but the drop in volatility prevented him
from making as much money as anticipated.
For a trader to become a successful options trader, they must understand the importance of volatility in the pricing of options. My advice would be to pick a group of stocks that you are very familiar with and stick to trading those stocks only. When you step back to consider a professional market maker on the floor of an exchange, they only trade a few products. They don’t need to trade numerous markets because they are experts in their products only. Retail traders should take this as a cue and become experts in their list of stocks. They should research levels of volatility on those stocks so they can get a feel for how that stock trades. Knowing the average size of a daily move on a stock and the normal levels of volatility will help in the process of selecting the proper options to play those stocks with. Understanding the role volatility plays in the pricing of options will provide a good foundation to work off of. With this foundation in place, a trader will then have the ability to use volatility as a guide in selecting the proper strategy to use when trading options.