Early in June, a company that we will call XYZ closed at $50 per share. The shares had moved sharply higher intraday on heavy volume. In fact, in this hypothetical example, the shares were up more than 50% since the beginning of the year. The intraday movement on this June day was the culmination of a month of activity, where most of the stock's year-to-date performance was generated. Technicians refer to this type of move as a classic blow-off.
What made this all happen? Perhaps a merger, maybe some startling news about a new drug -- reasons that we see driving stocks all the time. Pick the one you are most comfortable with for our hypothetical stock.
The reason for this illustration comes back to strategy selection. Allow me to put some numbers on the XYZ options. Let's assume that the XYZ September 35 puts, with three months to expiry are at $1.50 per share (For the record, put options rise when the value of the underlying stock declines). These puts are $15 out of the money, with less than three months to expiry. The volatility implied by these hypothetical puts is 80%.
What we have then is a stock with a classic blow-off technical pattern, and options at the extreme end of the volatility curve. Eight days later, our hypothetical stock plummets, closing at $40, down 20%. When the dust settles, the XYZ September 35 puts are trading at $1.50 per share, just slightly above your purchase price. I trust you see the problem.
Had you purchased the XYZ September 35 puts, you would have watched the stock fall 20% over a short period of time, and yet, would have watched your potential profits evaporate. The reason: the volatility embedded in the option evaporated.
What this hypothetical example demonstrates is the importance of strategy selection when using options to play your view on the underlying stock. It also serves to explain why technical analysts, without having proficiency in option-pricing mechanics, tend to have problems making profitable trades in the options market. It isn't just about making decisions as to what this or that stock will do over the course of time. You have to implement the correct option strategy to take advantage of the situation.
Simply stated, it is not as easy as buying calls because you think the stock will rise, or buying puts because you think it will decline. The price you pay to buy these instruments has as much to do in terms of making profitable decisions, as does your decision as to which direction the underlying stock is about to move.
One way to think about strategy selection is to think in terms of wagering on a football game -- bearing in mind that gambling and options trading are not inexorably linked.
Suppose you have the San Francisco 49ers playing the Chicago Bears in the eleventh week of the football season. Over the previous 10 weeks, San Francisco has won nine and lost one, while Chicago has lost nine and won one. Based on the year-to-date performance of the two teams, you would expect San Francisco to win the game.
But to make money on that decision, you have to make a wager. And since most observers have probably come to the same conclusion, no one will take the other side of that wager unless you are willing to pay a handicap.
What if the handicap were 50 points? That would likely change your outlook on the game. While you still may think San Francisco will win, for you to profit from that decision the 49ers now have to win by 50 points. That may be too much to ask.
In the same way, the options market handicaps the underlying stock market by making you pay a premium to play the game. If you pay too much for the premium, like the 50-point spread in the football analogy, you won't make a profit, even though the stock may move in the direction you expected.
Understanding the handicap is what strategy selection is all about. Problem is, the option-pricing formula makes it difficult to intuitively know whether the option premium is too high or too low.
Whereas most of us know that it is highly unlikely that any NFL football team will beat another NFL team by 50 points, it is not as easy to quantify whether $1.50 per share was too much to pay for an XYZ September 35 put -- with three months to expiration -- when the stock is at $50 per share.
One thing that makes football handicapping somewhat intuitive is the notion that we have clearly defined objectives. Two teams are playing. We think one will win. And we have a feel for handicaps that are over the top. More to the point, once the wager is placed, winning and losing is determined only when the game is over. We can't re-examine our position at halftime and alter the wager.
Perhaps if we apply that same logic to the options market, it will help us evaluate in a more straightforward manner whether an option premium is reasonable or out of line with our expectations.
One approach that might help investors become more intuitive as to option pricing is to re-examine their choice of strategy based on some of the more obscure calculations that are fed from the option pricing model. For example, delta tells us how much the option should move given a $1 move in the underlying stock. The XYZ September 35 put had a delta of -0.13 when the stock was at $50 (the negative delta reflects the fact that the put rises when the stock falls, and vice versa).
Based on these numbers, you would expect the XYZ September 35 put to rise 13¢ for every $1 decline in the price of the stock. Assuming all factors remained the same, the September 35 puts should have gone from $1.50 to $2.80 (an increase of $1.30) based on the $10 decline in the underlying stock.
To understand what happened in this case, we need to go back to the option-pricing formula. Specifically, we want to examine some of the other derivatives from the formula.
Theta, for example, is a derivative that tells us how much the option's price is expected to decline as it gets closer to expiration. The seven-day theta tells us how much of a decline is expected over the next seven days.
In the XYZ example, in late June the September 35 put had a seven-day theta of -0.16. That means we would expect the option's price to decline by -0.16¢ over the next seven days, assuming the stock price and volatility remain the same. We'll call it -0.18¢ over our eight-day period, which means that simple time value erosion will shave 18¢ off the original $1.50 price tag.
The other problem was the initial cost of the option in late June. The option was priced at 80% volatility. Eight days later, after the blow-out occurred, the September 35 put was trading with an implied volatility of 50%. Another derivative in the formula -- called Vega -- tells us how much the option's price will decline, based on changes in the volatility assumption. In this example, the option would lose 5.2¢ for every 1% decline in volatility, which takes another $1.56 off the option price.
Over the eight days, you lost $1.56 to declining volatility, and another 18¢ because of time-value erosion. After the stock declined by $10 per share, the September 35 put closed at $1.50 after, which means the decline in the stock price added $1.74 to the option price.
In short, the negative influences of a change in the volatility assumption and time-value erosion offset the positive influences from the stock price (remember, the put buyer wants the stock to decline). Bottom line: There was no profit, despite the fact you were right about the underlying stock -- as when San Francisco wins the game by less than 50 points.
The solution was to have chosen a different strategy. If the options are overpriced, write options rather than buy calls or puts. Sell naked calls or use put spreads, instead of buying puts outright.
Knowing what a stock is likely to do, or which team is likely to win, is not enough. In the options business, as with football wagering, you have to evaluate the handicap.
http://www.nationalpost.com/financialpost/story.html?id=6CB8B9B6-FAA0-4F09-B66B-BA84A1468316
What made this all happen? Perhaps a merger, maybe some startling news about a new drug -- reasons that we see driving stocks all the time. Pick the one you are most comfortable with for our hypothetical stock.
The reason for this illustration comes back to strategy selection. Allow me to put some numbers on the XYZ options. Let's assume that the XYZ September 35 puts, with three months to expiry are at $1.50 per share (For the record, put options rise when the value of the underlying stock declines). These puts are $15 out of the money, with less than three months to expiry. The volatility implied by these hypothetical puts is 80%.
What we have then is a stock with a classic blow-off technical pattern, and options at the extreme end of the volatility curve. Eight days later, our hypothetical stock plummets, closing at $40, down 20%. When the dust settles, the XYZ September 35 puts are trading at $1.50 per share, just slightly above your purchase price. I trust you see the problem.
Had you purchased the XYZ September 35 puts, you would have watched the stock fall 20% over a short period of time, and yet, would have watched your potential profits evaporate. The reason: the volatility embedded in the option evaporated.
What this hypothetical example demonstrates is the importance of strategy selection when using options to play your view on the underlying stock. It also serves to explain why technical analysts, without having proficiency in option-pricing mechanics, tend to have problems making profitable trades in the options market. It isn't just about making decisions as to what this or that stock will do over the course of time. You have to implement the correct option strategy to take advantage of the situation.
Simply stated, it is not as easy as buying calls because you think the stock will rise, or buying puts because you think it will decline. The price you pay to buy these instruments has as much to do in terms of making profitable decisions, as does your decision as to which direction the underlying stock is about to move.
One way to think about strategy selection is to think in terms of wagering on a football game -- bearing in mind that gambling and options trading are not inexorably linked.
Suppose you have the San Francisco 49ers playing the Chicago Bears in the eleventh week of the football season. Over the previous 10 weeks, San Francisco has won nine and lost one, while Chicago has lost nine and won one. Based on the year-to-date performance of the two teams, you would expect San Francisco to win the game.
But to make money on that decision, you have to make a wager. And since most observers have probably come to the same conclusion, no one will take the other side of that wager unless you are willing to pay a handicap.
What if the handicap were 50 points? That would likely change your outlook on the game. While you still may think San Francisco will win, for you to profit from that decision the 49ers now have to win by 50 points. That may be too much to ask.
In the same way, the options market handicaps the underlying stock market by making you pay a premium to play the game. If you pay too much for the premium, like the 50-point spread in the football analogy, you won't make a profit, even though the stock may move in the direction you expected.
Understanding the handicap is what strategy selection is all about. Problem is, the option-pricing formula makes it difficult to intuitively know whether the option premium is too high or too low.
Whereas most of us know that it is highly unlikely that any NFL football team will beat another NFL team by 50 points, it is not as easy to quantify whether $1.50 per share was too much to pay for an XYZ September 35 put -- with three months to expiration -- when the stock is at $50 per share.
One thing that makes football handicapping somewhat intuitive is the notion that we have clearly defined objectives. Two teams are playing. We think one will win. And we have a feel for handicaps that are over the top. More to the point, once the wager is placed, winning and losing is determined only when the game is over. We can't re-examine our position at halftime and alter the wager.
Perhaps if we apply that same logic to the options market, it will help us evaluate in a more straightforward manner whether an option premium is reasonable or out of line with our expectations.
One approach that might help investors become more intuitive as to option pricing is to re-examine their choice of strategy based on some of the more obscure calculations that are fed from the option pricing model. For example, delta tells us how much the option should move given a $1 move in the underlying stock. The XYZ September 35 put had a delta of -0.13 when the stock was at $50 (the negative delta reflects the fact that the put rises when the stock falls, and vice versa).
Based on these numbers, you would expect the XYZ September 35 put to rise 13¢ for every $1 decline in the price of the stock. Assuming all factors remained the same, the September 35 puts should have gone from $1.50 to $2.80 (an increase of $1.30) based on the $10 decline in the underlying stock.
To understand what happened in this case, we need to go back to the option-pricing formula. Specifically, we want to examine some of the other derivatives from the formula.
Theta, for example, is a derivative that tells us how much the option's price is expected to decline as it gets closer to expiration. The seven-day theta tells us how much of a decline is expected over the next seven days.
In the XYZ example, in late June the September 35 put had a seven-day theta of -0.16. That means we would expect the option's price to decline by -0.16¢ over the next seven days, assuming the stock price and volatility remain the same. We'll call it -0.18¢ over our eight-day period, which means that simple time value erosion will shave 18¢ off the original $1.50 price tag.
The other problem was the initial cost of the option in late June. The option was priced at 80% volatility. Eight days later, after the blow-out occurred, the September 35 put was trading with an implied volatility of 50%. Another derivative in the formula -- called Vega -- tells us how much the option's price will decline, based on changes in the volatility assumption. In this example, the option would lose 5.2¢ for every 1% decline in volatility, which takes another $1.56 off the option price.
Over the eight days, you lost $1.56 to declining volatility, and another 18¢ because of time-value erosion. After the stock declined by $10 per share, the September 35 put closed at $1.50 after, which means the decline in the stock price added $1.74 to the option price.
In short, the negative influences of a change in the volatility assumption and time-value erosion offset the positive influences from the stock price (remember, the put buyer wants the stock to decline). Bottom line: There was no profit, despite the fact you were right about the underlying stock -- as when San Francisco wins the game by less than 50 points.
The solution was to have chosen a different strategy. If the options are overpriced, write options rather than buy calls or puts. Sell naked calls or use put spreads, instead of buying puts outright.
Knowing what a stock is likely to do, or which team is likely to win, is not enough. In the options business, as with football wagering, you have to evaluate the handicap.
http://www.nationalpost.com/financialpost/story.html?id=6CB8B9B6-FAA0-4F09-B66B-BA84A1468316
