What makes some options premiums worth so much more than others? Let’s say we have two stocks, A and B. Both are trading @ $25/share. We look to sell the same month A-T-M $25 strike and one (stock A) returns 2% and the other (stock B) 4%. WHY? The answer lies predominantly in the mysterious world of implied volatility (IV). The volatility of an option reflects the fluctuation in the price of the underlying stock, both up and down. It does NOT predict a trend but rather a range of price change that the equity can have. In this case, stock B has a much higher IV than does A.
Let’s revisit our equation of the factors that determine the value of an option premium:Intrinsic Value + Time Value = Premium Value
Intrinsic value is the amount of money the strike is below the market value of the equity, nothing more or less. It is not affected by stock volatility or anything other than the value of the underlying security. Therefore, volatility of the stock relates only to time value.
Now take a big gulp of high-octane coffee as I give review some definitions:
Historical Volatility (Statistical Volatility): A statistic or statement of fact based on the closing prices over the past year. If a stock has had a trading range between $30 and $40 and has an average price of $35, we can say the historical volatility is $5 in either direction. A stock that moves up or down $5 from its average of $35 is said to have an HV of 14.3% (5/35). It does not predict a future direction.
Implied Volatility: This is the market’s estimate of future volatility and is based on the option’s last traded price. Stated differently, it is the volatility that the market as a whole is expecting that is giving the option premium its current value. If the historical volatility (HV or SV) is @ 14.3% and the current implied volatility is @ 30%, then that option is considered overpriced.
Common sense formulas:
As IV increases = Call premium increases
As IV decreases = Call premium decreases
Causes of implied volatility changes:
- changes in stock volatility
- supply and demand
- earnings reports
- rumors
- news
- market psychology and volatility
- world events
- political events
Mathematics of Implied Volatility:
In statistics, we often hear the term standard deviation. This means that a certain event will occur based on a statistical model, a certain percent of the time. Let’s clarify this with an example:
Blue Collar Investor Corp (BCI) is currently trading @ $60 per share (I wish!). A pricing model like the Black-Scholes, determines that, based on the current market value of the call option ($60 strike, for example), the IV is 25%. This means that the market is anticipating a price change of $15 (25% of $60) up or down. Remember it does not identify a trend. The expected range for the year currently is between $45 and $75 (plus or minus 25% of $60). The likelihood of this being accurate is 1 standard deviation or 68% of the time. It will fall outside these limits 32% of the time. Bottom line: When IV percentages are quoted, they are based on the current option value and on 1 standard deviation.
Where to access Historical and Implied Volatility Stats: Use this link for iVolatility.com:
http://www.ivolatility.com/options.j?ticker=SPX&R=0
You can access volatility charts which compare historical and implied volatility. Here is one such chart:
ADTN: Volatility Chart
This chart was captured a few days prior to the earnings report for ADTN. It is no surprise that the IV (red arrow) is higher than the HV (green arrow) as the market is anticipating a short term price fluctuation due to a potential positive or negative earnings surprise.
Market tone:
This article was written prior to my leaving on a short trip out of the US. I will be posting an abbreviated version of “market tone” upon my return on November 8th or 9th.
11-8-10:
As expected, the Fed announced that it will purchase treasury bonds to help stimulate the economy. The manufacturing and service sectors are showing expansion and last week’s jobs report was better than expected. Earnings reports were extremely positive with sales up over 7% on average and earnings rose nearly 45%. For the week, the S&P 500 was up 3.6% for a year-to-date return of 11.8%.
Summary:
IBD: Market in a confirmed uptrend.
BCI: Moderately bullish selling predominantly O-T-M strikes.
My best to all,
For Saul – #62 (of Penny Pilot blog) –
Due to your evidently efficient stock-finding technique, I will bet that if you find a stock on that, and also find it on Alan’s Premium Stock Chart Service, that this would be a wonderful find, an opportunity.
I have noticed that if some other newsletter source advocates a stock or ETF, and it is also on Alan’s, there seems to be some extra re-assurance of good potential. FWIW.
Don B.
Premium Members…
The Weekly Stock Screen And Watch List for 11/05/10 has been uploaded to the Member site. I will upload the ETF Report within 24 hours.
Barry
Premium Members…
The Weekly ETF Top Performers Report for 11/05/10 has been uploaded to the Premium Member site in the Member Resources Section.
Barry
Hello Barry –
Re the ETF Report, what became of the nine sector funds along with its top three performers?
Thanx.
Don B.
Thanks for the wonderful article again, Alan, wherever you are at the moment. . .
Since the IV is essentially based on the current option price and the current option price is based, among other things, essentially on the current IV, the question arises, which came first?
This question is answered easier with the hen and the egg.
I never saw an egg without a hen popping it, but there are plenty of hens without eggs. So, the hen came first. . .:>)
But with the IV it seems more complicated.
Especially when we deal with options instead of stocks.
The standard deviation, which Alan explained in the usual and perfect BCI manner, gives a good indication how big a stock range of movement we can expect (everything else being “normal”).
We could then use Delta to determine the resulting range of movement of the option.
Thing is, that the standard deviation move of a stock is calculated for 12 month, but we are mostly dealing with one month options.
There is a also a simple formula to predict the standard deviation for an option for a specific time.
One standard deviation move of a particular option= stock price x IV x Sq.-root of days to exp. and the whole thing divided by the sq.root of 365
Sounds complicated? Come on!
Let’s do a quick example;
Stock price = $45
IV = 20 (20 from hundred)
days to expiration = 30
45 x 0.20 x sq.root of 30 divided by sq.root of 365
That leaves us with a standard deviation of $2.58 for that option and gives us an indication what to expect.
At least 68% of the time. . .:>)
Cheers
Dirk
Dirk
The volatility is actually the chicken, in Dirk’s post. A stock can be volatile, even if it has no options available. The stock’s volatility is what creates the option premiums.
Examples: BAC (Bank of America). It closed Friday at $12.36. The Jan 2013 $12.50 call is $2.84. That means that the market seems to think this dog MAY only rise 24% in the next TWO years.
GE (General Electric) (52 wk = $13.65 – $19.43) closed Friday at $16.73. The GE Jan 2012 $15 call is only $2.83, and $1.73 of that is INTRINSIC VALUE!
Now, look at NFLX (Netflix) (52 wk = $48.52 – $184.74) closed Friday at $168.10. The Jan 2012 $200 call is $25.90.
THAT is what Implied Volatility does to options. The options traders, and covered call sellers, try to decide where the stock will be in one, two, nine, twenty-four months. Somebody is going to be wrong………and somebody is going to make money.
What does implied volatility do for one month options? Well, the NFLX Dec $170 is $10.15 (plus $1.90 upside possible). The GE Dec $17 is $0.19 (plus $0.27 upside potential).
Volatility equals profit. It also equals risk, but no risk is not profitable (just as someone with $10,000 in a one quarter percent FDIC insured bank account).
Any questions? Good. Ok, class is dismissed. Go work on our wish list for the December expirations.
Don B (Post #4)
Don,
Alan usually does the ETF report and I do the
Weekly Scree. I don’t have some of his tools, but I’ll update the ETF report with the 9 Spider Sectors in a few minutes.
Barry
Premium Members,
I just uploaded RevA of the ETF Report…it now includes performance information for the 9 S&P Sector Funds as well as the SPY.
Barry
Hi Barry,
thanks for your Sunday work.
Looks different today.
I like it!!!
Cheers
Dirk
Hello Dirk,
Alan mentioned that the ETF Report would be different this week. In order to produce the various reports, we have to subscribe to a wide variety of fee based data services and tools. I use a different set of tools than Alan does to get the data for our various reports. So I have to collect the data and present it in a usable format. My personal bias for data presentation comes through. Next week, Alan will be back producing the reports in the previous style.
Best,
Barry
Just curious, what is the effect of IV in 1-,2-,3-,4-month option premium?
Is there a correlation of VIX on any given stock/ETF with its IV at a certain period of time.
It’s good to be back!
Linda and I had a wonderful trip cruising the Mexican Riviera. Planning to write more covered calls before the credit card statement comes in! A few updates:
- I added an abbreviated market tone commentary to this week’s blog article.
2- All books and DVDs ordered to date will be shipped today.
3- I’d like to welcome all the new premium members who joined this past week and thank all existing premium and general members for your continued support.
4- As the BCI community expands, so does the volume of emails. I will read and respond to them all. I should be all caught up by the end of the week.
5- I have recently completed an updated seminar series (3 seminars) and created a new DVD series with a full color workbook. I expect this to be available within the next week or two.
All those on my mailing list will get first notification with discount information. To join my mailing list:
http://www.thebluecollarinvestor.com/joinfrnds.shtml
My best to all,
Alan
S&P500 CHART UPDATE…
After todays close, I checked out the S&P500 chart to see what went on. This is what can be found.
1) The last 2 days (5th and 8th of nov) represent a ‘harami pattern’. The Japanese will say with a harami pattern that the market is “losing its breath”. (NOTE: This can be observed using candlesticks, as can point 2)
2) The last day of trading (8th) seems to be a hanging man. This signal needs confirmation. If the next day of trading closes below this close, this can often be a strong signal of a reversal.
3) We are now at resistance level. In april this year we hit the same level on the SPX (S&P500) (when the bears took control of the market)
Will the bears take control? Will the bulls manage to fight their way through the ‘great wall of china’ (resistance)? In time, we will find out…
All the best everyone
Dave
Perhaps a point of interest in general. This morning, the Option Monster site reports a huge bullish activity in the DBA (agricultural) ETF. So I took a look at it, plus looked at MOO – which is of course on our BCI list. My impression is that the MOO is every bit as good a chart, and pays more option premium. Okay – the volatility is probably the reason, but nevertheless Agriculture is showing very strong fundamentals, according to some reports I have read. Hmmmm……………
Don B.
I recently sold 10 contracts of the November 17.50 for soa. If I bought back the options for 1.70 and sold the December 17.50 options for 1.70 I would make no money. Why isn’t the time value greater for the December calls?
Thanks.
Chris
Allan (#11),
IV is tied to the market perception of the price movement of a stock at that point in time. It is oftentimes tied to a particular event like an earnings report. Once the event passes, IV declines. Sometimes IV will remain high for a long time as it did with the dot-com stocks in the late nineties. In 2007 the commodity stocks were high-flying with high IVs of their options as the “BRIC” countries were becoming industrialized and building their infrastructures. So there is no general rule for IVs but rather tied to a particular stock or industry. Going out several months with your options will return a higher initial premium but a lower annualized percentage. One-month options will return the highest percentages.
The VIX has an inverse relationship with the market or S&P 500. It is one of the important BCI parameters when evaluating market tone. A declining VIX or a stable VIX below 20 is bullish and I would be more likely to sell an O-T-M strike for a high IV option. A bearish VIX signal would guide me to a lower IV option and/or sell an I-T-M strike. In our premium report we show the “beta” of our candidates which reflects the historical volatility of an equity. High beta stocks tend to outperform the market in an uptrending market while low beta stocks tend to outperform the market in a bearish or slightly downtrending market.
Alan
Chris (#15),
There are two reasons for this:
1- There is a farly wide bid-ask spread and you are selling at the lower and buying at the higher. You will make a slight profit by “playing the bid-ask spread”.
2- As the strike price goes deeper and deeper in-the-money, the time value does approach zero and the premium becomes predominantly intrinsic value. Use the “what now” tab of the Ellman Calculator to determine if a rolling strategy makes sense.
Alan
MARKET UPDATE!!!
The S&P500 yestarday shows a BEARISH engulfing pattern at resistance…
Watch the market closely!
SLH and the bid-ask spread:
On November 3rd, Solera reported its 12th consecutive positive earnings surprise with net income up 10% and guidance being raised for the next two years. As a result the stock recently hit an all-time high.
Despite the positive news relating to this great-performer, I am avoiding this stock. This is because of the wide bid-ask spread of the associated options due to lack of liquidity (interest). By playing the bid-ask spread we can generate a much higher return than the published bid price but the spread is still not favorable should we need to institute an exit strategy.
Locating a great-performer through fundamental and technical analysis is the first part of our system Accessing the options chain and running the calculations must also be factored in.
Alan
Alan & All,
Yesterday saw an upheaval followed by an elevator ride downward in the silver market. And I note today that SLW and a number of other mining shares display a very similar chart pattern (to each other). The news is that the requirements in the silver market for margin for futures has been raised from 5000 per oz to 6500 per oz. That’s what I read, but I wonder if it meant per contract?? Anyway, I recall that in 1980 when the Hunt brothers were buying like crazy that the Silver Users Ass’n put powerful pressure on, and they changed the rules in the middle of the game. They halted all buying, permitting only selling! Whiz,Bang, Crash. This according to a book written right after that called “The Silver Bulls”.
There has been considerable pressure put on the CFTC for quite some time now to force two majors from manipulating the silver market on the short side. I understand that there are two civil suits, one against each of the two major banks, about this. And I read that there are rumors of margin being raised on the gold futures market as well.
Nothing wrong, by itself, with raising margins on futures – but it smells bad, because that is the path that was taken back in 1980.
Your thoughts appreciated.
Don B.
Alan,
I just became a premium member. Can you explain what a neutral (sideways arrow) STO entry means?
Thanks for all your help.
Barbara
Don (#20),
Yes, per contract. Here is an article from yesterday’s WSJ that addresses this issue:
http://online.wsj.com/article/BT-CO-20101110-716141.html
Alan
Barbara (#21),
A neutral STO entry normally indicates that the stochastic oscillator is above the 80th percentile in an “overbought” position. This is not necessarily a reason to avoid the stock because it can remain there for months. We do, however, want to let our members know thab a trend reversal is opossible.
Alan
RVBD:
I’ve had a few offsite inquiries about the price decline from $58 to $29. This was the result of a 2-for-1 stock split on November 9th. If you owned 100 shares @ $58 you now own 200 shares @$29. The market cap (total value) did not change. Also note how this stock is holding its value this morning despite the huge drop in the price of Cisco.
Alan
Alan–
I read your book on Exit Stategy and have no problem understanding the 10%-20 % rules when the strike is made OTM.
I have a bit of a problem getting my head around ITM stikes. If ABC is at 100 and I sell the 95 call for a premium of 7, then I figure 5 is intrinsic and the TV might be 2 with a total premium is thus 7.
If the stock drops suddenly to 96 –now there is an intrinsic of 1, and since the TV rises when the strike approaches the stock value, the TV might go to 3 . The total premium might be therefore be 4. So TV has actually gone up even though the total premium has dropped because of the drop in intrinsic value. Since the TV has not decreased do I stay put. I would have to wait until the stock dropped further before the TV dropped to 10% (or 20%) and I would exit. Am I right. Maybe I should always wait until all of the intrinsic is gone and then observe when my premium which is now all TV drops below the original TV.
In the book you sort of disregard the intrinsic value with ITM calls.
Could you clarify how you would trreat the 10% rule with respect to deep in ITM options which might drop in value. Am I just making it too complicated.
Sorry if I didn’t make myself clear.
mike
Mike,
You are NOT making things too complicated, you are actually asking a GREAT question. As a matter of fact I will add my following response to my soon-to-be published third book:
First a general point: In my book on exit strategies I lay out a SERIES of parameters to consider and the 20%/10% guideline is one of them. Every effort was made to make each parameter applicable to as many situations as possible. That being said, the reason that the 20%/10% guideline works for both I-T-M and O-T-M strikes has to do with the different deltas each option is associated with. Delta is the amount of change in an option value for every $1 change in share price. I-T-M strikes have the highest deltas (between .8 and 1.0) and O-T-M strikes the lowest (.2 to .3). A-T-M strikes are in between.
Let’s create some hypothetical numbers to clarify with the understanding that these are general numbers that can vary from stock to stock and situation to situation. Overall, however, the thinking has significant application to most scenarios:
1- We own a stock @ $53 and sell the I-T-M $50 call for $4. Let’s assign a delta of .8 to this call which means the option will drop $.80 in value for every $1 of share depreciation. If the stock drops by $4 to $49 the option value could be $.80 ($4 – $3.20). This will meet our 20% guideline.
2- We own a stock @ $48 and sell the O-T-M $50 strike @ $1.50. We will assign a delta of .3 to this option. If this stock also drops $4 in value to $44 the corresponding option value will be $.30 ($1.50 – $1.20) which also meets our 20% guideline.
Now although these stats were created to make a point, the deltas are accurate and the option returns and protection are reasonable. The point isn’t to examine these figures in detail but rather understand the relationship between strike price and delta and why that makes the 20%/10% guidelines applicable in most situations.
Thanks for the question as my next book now becomes a paragraph longer!
Alan
Alan – your #26 –
To try to put your #1 in my simpleton terms, then, one could say that one subtracts the delta (your .8) from the amount that the stock has dropped from what one paid for the stock. Never mind how much it is ITM. To be able to figure the 20%. Yes?
On OTM calls, I always thought one merely calculates 20% of what one received in the original STO to stay within the parameter?
Not so?
Thanx much.
Don B.
Allan,
I am half weay through your DVD series and really learning a lot. I especially liked the segment on technical analysis as I never really understood it before. My question is if you give more weight to any one of the technical indicators or are they all the same?
Thanks and keep up the good work.
Ted
ETF Report just uploaded:
Premium members will note that during the past three months the top-performing ETFs are up in value between 17% – 50% while the S&P 500 has appreciated by 12%. Look in the “resources/downloads” section of your premium site for the report dated 11-12-10.
Alan
Don (#27),
All strikes are calculated the same using the 20%/10% guideline. I mention the differing deltas to explain why this works for all strikes. There is no need for you to calculate the deltas. If you sold an I-T-M strikes for $3, consider buy back @ $0.60 and $0.30. If you sold an O-T-M strikes for $2, consider buy back @ $0.40 and $0.20. You are guaranteed an option return of 80% to 90% of the original premium by following these guidelines as you deal with the stock appreciation or depreciation.
Alan
Ted (#28),
I consider all technical indicators important but I must state that I will not consider purchasing a new stock without the following chart pattern:
1- Uptrending 20-d and 100-d EMAs with the short term above the longer term EMA.
2- Price bars (or candlesticks for those who prefer that chart pattern) at or above the 20-d EMA.
Technical analysis is an art as well as a science. We are weaving a mosaic of indicators as we formulate stock selction, buy-sell decisions and strike and exit strategy decisions.
Alan
Alan–
Thanks for your rapid response to my question about the 20/10 rule as it applies to ITM options where there exits intrinsic value as well as TV.
I think I now better understand my area of confusion. When calculating the drop in option value to determine if it has met the 80% drop, do you compare the original total option premium ( intrinsic and TV) and the final total premium, including intrinsic values, or should you determine and compare only the bare TV’s by subtracting the intrinsic values.
In your example #1 you compare the original premium ($4) which is composed of $3 intrinsic and $1 TV, with the final premium of .80 which is all TV. Or would it be correct to compare the original TV of $1 with the final TV of .80. In this case the drop in option value has not met the 20% criteria since .80 is greater than 20% of 1 (.80/1=.80).
It is true of course, that compared to the total initial option premium of 4 the option has fallen .80/4= .20
I’m sorry to take up your time with trivia but I find surgery easier to understand. I promise to drop the subject after this.
I await your next book.
mike
Mike,
This isn’t trivia. You have asked a good question. If a BCI is miscalculating any portion of the math in options trades, it can have a tremendous impact on the outcome. The 10%/20% suggestion is simple in its purpose and calculation, but it is important to understand.
First, the purpose: If an option premium is currently at 10% to 20% of the original price, it means that there is not a great deal of profit left to make it worthwhile holding out for expiration Friday.
Second, the calculation is based on your original option trade. It has nothing to do with time value or intrinsic value of the option premium.
Let’s use your $4 option premium above for 100 shares of XYZ. You receive $400 for the premium. When it reaches between $0.40 ($4 x 10%) and $0.80 ($4 x 20%) you look at closing it. If you keep the position open you stand to make the remaining $40 to $80. If you closed the position you would lose that amount of your potential gain. Why would you do that? Simple: a greater reward.
Now, suppose you can get a $2.75 premium for the same strike for next month. If there is no earnings report, and the stock still meets the BCI tests, why not give up $40 to $80 dollars in possible gains in exchange for an additional $475 in possible gains?
Another alterenative is that selling a different strike on an XYZ option for the same month may earn you more than what you are giving up closing it early.
A third alternative is that just closing out the entire position (buyng the option to close and selling the stock) may lock in a decent profit (not quite what you had in mind when you entered the trade, but still decent) and free up the cash to enter another trade right now that will earn you a very good return.
Basically it comes down to a tradeoff in gains. If you give up $80 today, but you can earn another $380 using the same stock, or same money, why wait? If you wait to squeeze that last $80 out of the trade, the opportunities you are looking at to replace it today may be gone when expiration Friday arrives.
It still comes down to the bottom line …. earning capital gains. One $400 gain is not as good as two $320 gains, is it? I will give up $80 to earn another $320 just as often as I can.
Sorry, flying fingers. In the paragraph with the $2.75 premium the possible gain is $275, not $475.
Alan & all,
I hope I am not out of line here. But I wish to bring up SLV as an issue. You may notice that it is at the top of our ETFs at this time. There is some chagrin in some important quarters about the existence of very serious market manipulation of this fund. At this point, there are said to be two civil suits leveled at the two companies involved, JPM is one, from two different sources.
I shall not attempt to tell the story here. However, one might click on j@silverstockreport.com. That is a small letter J at the beginning. This report dated today 13th is thorough and offers many links for detailed study of the matter. The main issue is that the SLV is said by the antagonists to not possibly be able to have the silver they say they have, since that quotable quantity is greater than the amount that is dug out of the ground! (My simple terms.)
The writer believes that JPMorgan Chase (who owns or controls – ? – SLV) is SHORT such a dramatically amount of silver which does not likely exist. Anyway, look into it and see what you think. Just my thoughts out loud.
Don B
PS – In my #35 above, I should have said to click on that link and ask for a email copy of the report of the 13th involving that silver market manipulation.
Apple put spread update:
The $300 put that I sold for $1,166 is now down to $215, because Apple is $308 per share, and the option only has a week to go. The $290 put that I bought for $766 is now $89. If I close the spread on Monday morning at these prices I will keep a gain of $274 out of the possible $400.
Now, do I feel lucky? Do I believe that Apple’s $8.63 fall on Friday from $316.65 to $308.03 is not going to continue? Ummmmm, maybe. I will watch it Monday morning and see what the sentiment seems to be. $274 is better than $63, or zero. Even if I close it out, I will make 27.4% (for one month) on the $1,000 Schwab put to the side to protect themselves from my foolishness.
This is what Alan’s Exit Strategies book is about. I’m a week away from expiration, and facing the distinct possibility that Apple could drop below $300 (remember, this blog is about volatility, and Apple is one seriously volatile stock). I cannot just go to the Alaskan wilderness, for next week, and hope for the best. I have to keep my eye on my position, and decide if I want to close it early. Okay, it won’t be for the $400 profit I originally hoped for, but a $274 profit on $1,000 in three weeks? Come on people, remember the “pigs get slaughtered” part of the Wall Street mantra? I do.
Don (#35),
We welcome and VALUE your comments and the information you provide to this site. The ETF report provides us with a list of the top-performing securities (with options) over the past 3 months. You are absolutely correct that the news of the day can impact those securities but generally what we know the institutional investors also know and is factored into the current price. That being said, the posts you and other members are kind enough to provide to this site can only enhance the quality of our investment decisions.
Thank you.
Alan
Anyone remember Nelson and Bunker Hunt? In the 1980′s, when gold hit $500, silver hit $50. The Hunt brothers had a couple of billion dollars they inherited from their father. They bought silver futures, on margin. At one point they controlled more than 25% of the known silver supply in the world through their futures contracts.
Then silver crashed, with gold, back to realistic levels, and the Hunt brothers both filed for bankruptcy. Maybe staying away from SLV and JPM is a good idea for a while. Or buy puts on them.
Alan, Owen, & all,
Let me add a few things here. There was a book back around 1980 about the Hunts and their involvement with the silver futures market, called The Silver Bulls. What it maintains is that there was powerful manipulation against them by the Silver Users Association. The bros were playing by the rules. But the Ass’n got to the powers that be change the rules in the middle of the game, preventing new buys in that futures market, allowing only sells. Well, the silver crashed from $50, causing that bankruptcy of the wealthy brothers. BTW, the gold hit $850 that year, while silver was right at its highs. If I may repeat myself, I have read in more than one place opinion (emphasize opinion) that there is little or no silver being moved into vaults for that SLV. Think about it – how could that much be stored? FWIW.
Don B
Owen – on your highly informative #37 –
Curious as to how “Chuck” got you to $1000 as cash backing for a $300 sold Put. $300 times 100 is 30 k isn’t it? Does this have something to do with your being long the put?
Don B