Forbes Article
Wednesday, July 11, 2007 at 10:05AM I wrote an article for Forbes 3 weeks ago and went to check it out on their site today, and it wasn't there. Aside from feeling neglected, I think there might be some good facts in the article, so I am going to post it here first. The trade example will prove just how old it is, but still might be helpful for some.
Weigh Your Options
Jeff Kohler, Investools.com
Before purchasing a new car from a car dealership, you need to determine if the car is over- or underpriced. Luckily, there are several resources to help consumers find the fair market values of the automobiles they want to purchase. If customers know what the fair prices are, they can avoid paying unreasonable prices.
Imagine walking into the options market under the same circumstances. You have a great stock in mind, and are looking to use options to profit from this idea. You narrow it down to the make and model you want (month of expiration and strike price); however, now you must examine the option premium to determine whether it is over- or undervalued.
When trading options, there are a couple methods you can use to determine whether options are over- or underpriced. The first method you’ll want to use is the Volatility Index (VIX), see Figure 1.
Weigh Your Options
Jeff Kohler, Investools.com
Before purchasing a new car from a car dealership, you need to determine if the car is over- or underpriced. Luckily, there are several resources to help consumers find the fair market values of the automobiles they want to purchase. If customers know what the fair prices are, they can avoid paying unreasonable prices.
Imagine walking into the options market under the same circumstances. You have a great stock in mind, and are looking to use options to profit from this idea. You narrow it down to the make and model you want (month of expiration and strike price); however, now you must examine the option premium to determine whether it is over- or undervalued.
When trading options, there are a couple methods you can use to determine whether options are over- or underpriced. The first method you’ll want to use is the Volatility Index (VIX), see Figure 1.
Figure 1 – Volatility Index (VIX)The VIX is commonly referred to as the fear gauge of the market. It measures implied volatility (fear) of S&P 500 Index options. Subsequently, options are priced by this fear. If the VIX is relatively high, options will be expensive. If the VIX is relatively low, options will be cheaper.
Figure 2— One-year chart of the VIXFigure 2 is a one-year chart of the VIX, to help illustrate where the VIX should be considered high and where it should be considered low. Notice how the VIX is currently on the high side of its recent price trend, which means that options are generally priced higher. Use this measurement to help determine your trading strategy. If you can see that options are expensive, consider strategies where you are on the receiving end of these premiums. Alternatively, if options are cheap, consider strategies where you are the purchaser of these premiums.
After you have determined how the marketplace has contributed to the overall pricing of options, you will need to determine how options are priced on the stock you are looking to trade. For an example, let’s look at Bear Stearns (BSC) in Figure 3.
Figure 3 – Bear Stearns (BSC)The banking and broker/dealer indexes are heading lower and Bear Stearns is breaking through a major level of support. The company attracted some negative press regarding a few of its hedge funds, and the stock price is generating some good signals indicating that it is likely to continue moving downward.
The next task is analyzing the BSC’s options. In general options are expensive, but you should check the options you are trading to see whether they are high or low priced. Figure 3 Includes a graph of the average implied volatility of Bear Stearns options. For a larger sample, see Figure 4.
Figure 4 – Bear Stearns Option PricingFigure 4 displays how options are priced on Bear Stearns, and as you can see, the fear gauge is higher than normal. Because the options are relatively high priced, you wouldn’t participate in a buying strategy, but instead, you would focus on selling strategies.
A common strategy employed to take advantage of high-priced options, while limiting your risk, is a bear call spread. This strategy is accomplished by buying and selling call options with the same expiration month but different strike prices.
The July 145 call is currently bid for $2.90, while the July 150 call is asking $1.55. To execute this strategy you would sell the 145 and collect $2.90, and buy the 150 call for $1.55. This would leave $1.35 in your account (2.90 – 1.55 = 1.35).
Before you start looking for places to spend this money, understand that you are unable to use this premium until the trade is closed. If the stock closes below $145 at expiration, both options expire worthless and the premium is yours to keep. If the stock closes above $145, you’ll need to calculate your maximum risk. To determine what your maximum risk is in this trade, you will take the difference between the strike prices (150 – 145 = 5) and subtract the premium received ($1.35). This means that your trade has a maximum loss of $3.65 (5 – 1.35 = 3.65).
It is essential to find the right stock to create a higher probability of a successful trade. For the bear call spread, look for a downward trending stock, like Bear Stearns. With all the negative press on the company, this trade has an even higher likelihood of profit.
Options pricing can weigh heavily on finding the most appropriate strategy to participate in. Remember to glance at the fear gauges of the market and your stock before choosing an option strategy. It could make all the difference between profits or losses in the options market.
Recommendation: I will try to tone it down a notch today.
Long: Volatility
Short: Theta
Reader Comments (6)
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Figure 4 displays how options are priced on Bear Stearns, and as you can see, the fear gauge is higher than normal. Because the options are relatively high priced, you wouldn’t participate in a buying gucci outlet strategy, but instead, you would focus on selling strategies.
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