We already discussed what an option is, and how it can help with risk management. When I was talking about risk management, I was talking about how options require a lot less margin to make the same amount of money on a stock. Why wouldn’t everyone do it then? In short, it is because there are three things to consider when investing in options rather than the single variable in stocks. When you master these three variables however, investing in options is the clear superior investment vehicle. I’m sure you have heard of the “Greeks” when dealing with options and their importance. While they are extremely important, they boil down to a measurement of 3 variables. So I will go over those three variables, then explain how the Greeks are derived from them, and how to treat the Greeks in your trading. While looking at these variables, I’m going to have an example option, and bold the significant part of the options as it relates to the variable to help you follow along.
Stock Price – February AAPL $100 call @ $.89 IV 21.20
The first and most obvious variable is the stock price itself. If you buy a call, and the stock goes up, you will make money. While this variable is the easiest to understand, it is the most important. Your thesis determines how well your trade pans out. There is no way to avoid it, if you are wrong in your thesis, you will lose money. No plan will save you.
While that is true, if your plans are well formed you can make money if your thesis is correct only 50% or even 40% of the time. With stocks, you must be right more than half of the time to make significant money. This is reflected in the armies of researchers employed by hedge funds and banks, as knowledge is the traditional edge in the market. Now, markets are driven by speed of trades, liquidity, and pricing inefficiencies. The average retail investor doesn’t have close to the amount of money these hedge funds and banks have. The average retail investor cannot compete with any of that, and is at a major disadvantage in all types of trading because of it. Most retail investors I talk with range between capitulation and treading water when it comes to the market. How can we tip the scales in our favor?
Most of you are aware of this, and rely on theses that try to even the playing field just a little bit. Another way is to have plans that limit losses when wrong and have greater gains when right. Options allow you to do this.
Implied Volatility – February AAPL $100 call @ $.89 IV 21.20
It is catalyst time. You learn that this PDUFA is going to result in a positive outcome. The stock is at $30, you decide to buy a $50 call for $1. This is going to be sweet! Results come in… FDA approval!
You sit down in your desk chair and lean it back resting your feet on the desk. You give your dog a quick pet, you cut your Churchill Romeo y Julieta cigar and light it as you log into your account. The stock is at $45 at 9:45, the option price is…$.75??!!? The stock is up 50% and your option is down 25%? You just got punked by volatility.
Implied volatility is simply the demand for the option itself. This demand is driven by the expected movement in the stock. So naturally when there’s a catalyst or earnings expected, the implied volatility is raised. When that catalyst is over, the expected movement decreases as does the price of the option itself as it relates to the underlying stock’s price. This is no reason to fret, in fact, this is an extremely important variable to understand in order to even help your stock positions. Let’s look at the GILD chart as of 2/1, 2 days after the MRK approval of a competing Hep-C drug.
Let’s say you knew nothing about GILD. This chart is the only information you have. About a week ago, the IV was at 33, but then IV skyrockets to 60! Then the news hits, Zepatier is approved, the GILD goes from $87 to $83. Along with the news, the IV starts its descent. If you didn’t know about Zepatier, you should have known something was brewing when that IV shot up. This should excite you because all those hedge funds who know more than you do just telegraphed their move!
This leads to my number 1 rule for catalyst trading: Always have a short volatility trade (in or out of the money) when the date of it is known. Volatility will always go down when the catalyst is over. This means instead of buying a call when bullish, you sell a put. If you don’t have enough money to sell a put, you can leverage with buying a lower valued put (a strategy called a vertical which I will describe in the next article). There are no exceptions to this rule. When you are selling your house, wouldn’t you rather have 5 people bidding on it than be one of those 5 people doing the bidding?
This leads to another question… why don’t all those banks and hedge funds do the same thing? I have spoken to a couple of portfolio managers about this, and their answer is because generally they use options to hedge their positions. So if someone is bullish on GILD but know the MRK catalyst is coming, they just buy puts to minimize the damage since it costs less margin, which is an effective strategy for them. The same is true for overall market volatility. The VIX is a measurement of option volatility in SPX (not the 'fear' index). Since most portfolios lean long, when there’s a sign of downturn the VIX goes up. This is why in general when the market is down the VIX is up, and vice versa. Now that you understand this important aspect of options, you can use it to your advantage and profit greatly from it.
It is important to mention the effect of time on IV. Because there is more of a chance for bad things to happen the further expiration day is, volatility has a greater impact. This is important for a calendar strategy that I will explain in the next article.
One final small note about IV. The number itself is the relative standard deviation in a monthly move in the underlying. However, when looking at the number I use it on a relative basis. For instance, GILD’s IV at 60 vs. 33 is only good in relation to its historical IV when formulating trades. You need an IV chart like the one above to see if the IV is high or low, and trade accordingly. The option premiums will reflect these numbers, so it is best used when creating strategies to understand how much the underlying has moved historically.
Time - February AAPL $100 call @ $.89 IV 21.20
One interesting aspect of options is the expiration date. For all American-style options, the best possible price to buy an option that is exercised immediately would give a value equal to or less than than the stock price + the premium (or reverse for a put). Otherwise some computer would buy that option, exercise, and sell within a nanosecond. Since there is a deadline to reach the strike price, the extrinsic value decreases as time wears on. Time is also not a variable, it is an exponentially decreasing constant, since it doesn't change.
When you by a call with 15 days left, something big an unexpected had better happen soon, or time will eat at your option value. But if you sold a put instead of buying a call, that curve is in your favor! You want time to go as fast as possible! I call time (or theta) the house advantage. Why wouldn’t you want to be the house? For rangebound trades, you always want to be theta positive.
So now you know all about the three variables of options. The greeks are a measurement of those three variables, and the values are given by the Black-Sholes model.
Congratulations! You now know enough about options to hold your own in a bar conversation. While this seemingly makes options more complicated to trade, it actually makes them a lot more flexible. You can tip the scales of risk to reward in your favor by understanding how stock price, volatility, and time affect your trade, and align your ideas more closely to your thesis.