Browse > Home / Archive: February 2005

Option Volatility

February 23, 2005

The Smart Profits Report: Issue # 186
Wednesday, February 23, 2005

Option Volatility: A Free Tool for Finding the Best Option Bargains
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

When it comes to option trading, you can either buy them when they’re cheap or buy them when they’re expensive. Do you know how to tell when they’re expensive and when they’re not?

I’ll give you a hint: It all depends on the “option volatility.”

There are six factors that determine the price for an option contract.

  • Price of the underlying stock
  • Strike price of the option
  • Time to expiration
  • Volatility
  • Interest rates
  • Dividends

All of the factors except for “volatility” are either set by the options exchanges or are readily available information for everyone to use. Volatility is the only factor that is not universally accepted by all market participants.

So to get a leg up on the markets, you need to understand the sole remaining factor: volatility. It gives you a way of knowing which options are bargains, and which are not.

Here’s what I mean…

How to Quantify Volatility In Options

Volatility, as it applies to options trading, is a number that quantifies how volatile the underlying stock has been in the past, as well as how volatile it is expected to be in the future.

There are two types of volatility that relate to options trading:

  • “Historical volatility” measures how erratic, or volatile, the stock has been in the past…
  • “Implied volatility” (or beta) measures the options market’s view of how erratic, or volatile, the stock might be in the future.

Since there are different time frames in which to measure volatility, as well as different ways to calculate volatility, you can guess that the volatility factor that goes into pricing an option can be confusing.

Some traders like to use a 10-day, 30-day, or 50-day historical volatility in pricing options, while others like to use the current at-the-money implied volatility of the front-month options.

Some like to calculate the volatility using the closing price of the stock, while others like to incorporate the high, low and close of each session.

Regardless of how the volatility is calculated or which measure is used, we are not concerned with that in this discussion. We are concerned with how to tell whether options are expensive or cheap before we buy them.

Volatility can tell us just that. When it comes to determining whether options are cheap or expensive, it’s the volatility that gives us the clues.

Critical to Success: Buying When Volatility Is Low

Just like a regular stock chart, volatility fluctuates in the same manner. Volatility will oscillate between high and low. Your job as a Smart Profits trader is to know whether volatility is at a high or low level before purchasing your option contracts.

Of course, buying when volatility is low is a must… and one of the best ways to put the odds of success on your side. How do you tell if volatility is high or low?

Just look at a volatility chart. These are published at various websites, and if you use a data provider to receive charts and quotes, some provide historical and implied volatility as available indicators. One of the best websites I know of to see volatility charts and volatility statistics is http://www.ivolatility.com.

Why is it important to buy options when volatility is low? Because volatility has a direct effect on the price of an option.

When a stock is fluctuating wildly, that means the stock is volatile, which in turn increases the volatility component. When volatility increases, so do option prices. When stocks are stagnant, volatility decreases, which in turn brings down the option premiums.

An Volatile Example Using IBM…

Just as an example, if you look at a one-year volatility chart for IBM at ivolatility.com, you will see that the implied volatility hit a peak of 25% at the end of March 2004, and is hitting a low of around 13% at present. If you priced out the IBM March ‘05 $95 call with a volatility level of 13% using an option calculator, you will yield a premium of $1.40.

Now, if you substitute a volatility level of 25%, the same $95 call will cost you $2.97, more than double the price when compared to the lower volatility number. (Remember, when volatility increases, so do option prices…)

What Option Volatility Means for You as a Trader…

What does this mean for the option trader? Well, it means that if you plan on buying an option, you better check the volatility level to see if you are buying a cheap or expensive option. If you buy an expensive option and the stock doesn’t move in your favor right away, not only will you lose because the direction was wrong; you will most likely lose even faster if volatility starts to come down.

If you buy an option when it is cheap and the direction goes against you, you won’t lose as fast because the volatility is already low and it won’t suck much more value out of it because of that.

Bottom line here is to always make sure you’re aware of the volatility levels before initiating an option position. As you take in all the other factors before making a trading decision, such as technical and fundamental issues, why not add another tool to your arsenal to increase your odds of success? Check the volatility!

Good trading,

Lee Lowell

Sign Up for The Smart Profits e-Report!

Today’s Smart Profits Cribsheet

  • For more on volatility, check out Karim Rahemtulla’s take on it in Smart Profits #107: Using Volatility: How to Pay $27 for a $50 Stock.

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2005 | Leave a Comment 

Derivatives

February 17, 2005

The Smart Profits Report: Issue #185
Thursday, February 17, 2005

Derivatives: Take the Big Guys’ Money With Their Own Weapons
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

Someone’s making money - why not you?

Derivatives such as options were once thought to be “exotic” trades. They were obscure, hard to use and best left to professional traders and high-powered institutions.

Guess what? Not much has changed. Traders and professional money managers still use them more than regular investors do. But change is coming.

I have often pondered why an options/futures market has existed for as long as it has. These markets have been around for 40-odd years and still I doubt that more than 1% of the investment public dares to use options as an investment tool.

I am sure this sits well with the pros, since it means they still have unfettered access to this money machine.

Derivatives Survival

But if few are using derivatives like options, why is there a market at all? Think about it… How can a derivatives market survive for as long as it has unless someone is making money?

The answer, of course, is that someone is making money. Any business, except one subsidized by the government, is bound to fail unless it makes people money. The only problem here is, it hasn’t been the average investor who has cleaned up.

That’s changing, and if I have anything to do with it, it will change even faster.

We need to be the “people” profiting from this market. The only way to do so is to understand how this market works, how to use it, and then take full advantage of that knowledge.

Here’s one way we can do that…

Three Ways to Use Options to Your Advantage

What you must get over is that options are NOT a weird investment vehicle to be feared, but a tool that the market has provided to use as a proxy to buying and selling stocks.

The first step is to actually learn one strategy that makes sense to you. Just one.

It could be “put” selling, covered call writing, LEAPS trading, spreads, straddles, or a host of other trading strategies. It doesn’t matter a great deal where you start as far as the learning process goes.

With options, you can choose a strategy to accomplish any number of trading/investing goals.

A few examples:

  • If you want to own shares of company but it is too expensive right now, you can sell a put. By selling a put you collect money for nothing - except the obligation to buy the stock YOU ALREADY WANTED for the PRICE YOU WANTED TO PAY FOR IT.
  • Do you now own too many shares of a single company’s stock? Nothing is more dangerous than being overweight in a single company. Instead of being so exposed, buy some three-year LEAP options as a proxy for the shares. It may cost you 10% or 15% of your capital. The other 90% can sit in the Treasury bill earning money to cover 60% of the cost of the LEAPS. Of course if the shares move up, you will make a ton of money either way, but with fewer dollars at risk if you use LEAPS.
  • Can’t decide which way a stock is going to go? Do a straddle trade where you go long and short at the same time. So then when your big announcement comes and the stock soars… or dives… you can still win while controlling your risk.

Derivatives such as options are NOT dangerous, investors are. We need to conquer that fear of doing something stupid with options. The only way to do so is to become educated investors, investors who operate with confidence, smarts and a strategy.

Good Trading,

Karim Rahemtulla

Sign Up for The Smart Profits e-Report!

Today’s Smart Profits Cribsheet

  • In today’s report, I talk about put selling. For more info on this, check out Smart Profits #278, Selling Naked Puts - Get Paid Now To Buy Your Favorite Stocks Later… At A Bargain.
  • Also check out our Smart Profits Glossary for more detailed information on some of the terms used above like “derivatives” or “exotic trades.”

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2005 | Leave a Comment 

Limit Orders vs. Naked Put Selling

February 15, 2005

The Smart Profits Report: Issue #184
Tuesday, February 15, 2005

Limit Orders vs. Naked Put Selling: Getting Paid to Place Them On Your Favorite Stock
by Lee Lowell
Advisory Panelist, Mt. Vernon Research

Did you know you could have someone pay you cash today while you place a limit order on your favorite stock? It’s true. Just for your effort of placing a limit order on a stock below its current price, someone will give you cold, hard cash.

When you want to buy a stock at a lower price, what do you do? Most people would put in a limit order below the stock’s current price and hope and pray the market sells off. I’ll show you a way to use your money more efficiently while you wait for the market to come down.

I’m going to show you a method of using a certain kind of limit order through an option strategy called “naked put selling.” Which is a slightly different strategy than from what most people would use.

Why You Shouldn’t Worry About Selling Naked Puts

Now don’t get worried about seeing two of the more aggressive option terms in this strategy - “naked” and “selling”. If you’ve ever traded options before, you know that selling naked options entails unlimited risks. But with naked put selling, the risk is for a good cause - buying your favorite stock at a lower price.

I must emphasize this next point very strongly. You MUST only sell naked puts on stocks that you DEFINITELY want to buy and keep in your portfolio.

If you sell naked puts just to receive the premium and don’t have any intentions of owning the stock, then this article is not for you. Selling puts just to receive the premium income is a speculative play and more of the gambler’s type of trade. We don’t want that with this strategy.

Limit Orders or Naked Puts? This Isn’t Mickey Mouse…

Okay, so how do we do it? Let’s take Disney (NYSE: DIS) for example. It has been in a nice uptrend and also hitting close to four-year highs, around $29. You’d like to get in and buy some but don’t want to buy at its current high price, as you feel a pullback is due to happen.

You think DIS may retrace to its 50-day moving average, which is currently around $25. You also think this may happen within the next two months.

At this point, you could be like many other investors and just put in a limit order to buy the stock at $25 and wait to see if you ever get filled.

Or, you can look at DIS put options and see what they are trading for. As of Feb. 3, 2005, the DIS April ‘05 $25 puts had a closing bid of $0.15. If you sell puts, two things happen:

  • You will get paid.
  • And, just as with a limit order, if the stock falls below $25, whoever buys the puts will exercise. And you’ll get what you wanted… Disney stock at $25.

When you sell puts, for every contract you sell, you will get $15 deposited into your account. (There are 100 shares per contract, so $0.15 x 100 = $15.) You wouldn’t get that money if you put in a straight limit order on the stock.

What We Want Put Options To Do For Us

Now, if you’ve ever sold put options before, the only way you will get assigned on the option is if the underlying security trades below the strike price at expiration. That’s what we’re hoping for in this case. We want DIS to trade down to $25 so that we get assigned and have 100 shares of DIS deposited into our account.

So how is this better than just putting in a limit order and waiting for DIS to trade down to $25?

Well, for starters, since we sold the put option for $0.15, we’re effectively lowering our cost basis to $24.85 per share, whereas the straight stock buyer has to pay $25 per share.

Also, we’re getting paid $15 up front for our efforts, which goes into our account, which will earn interest along with the rest of our available funds. But that’s if you’re right the first time… it can get even better.

If You Lose, You’re Still Making Money with Naked Puts

Now, if DIS never trades down to $25 by expiration, what happens? Well, the put buyers won’t exercise, and you won’t get to buy the shares for $25. But you will keep the $15 you were paid for the opportunity.

And then you can do it again. You can sell puts for the next expiration and see if you get assigned the shares. If you never get to buy DIS you have consolation knowing that at least you’re bringing in cash flow, which helps the return on your available funds, whereas the straight stock buyer is just earning the paltry 1% interest paid by most brokerages (if they pay at all) with no extra $15.

If you’re in the market to buy stock, don’t let anyone tell you that selling naked puts is riskier than owning stock.

After all, what’s your risk when buying stock? Your risk is that the stock falls to zero. What’s your risk with selling naked puts if you get assigned the shares? Your risk is that the stock falls to zero.

It’s exactly the same risk as owning stock outright… But with naked put selling, your cost basis is lower because of the premium you receive upfront.

So the next time you’re looking to buy some stock below its current price, think about selling some put options.

Good Investing,

Lee Lowell

Sign Up for The Smart Profits e-Report!

Today’s Smart Profits Cribsheet

  • Today I talk about puts and “naked” options (options traded without the underlying stock). For more on put options, check out the Smart Option archives. Specifically you can revisit Smart Profits #102, Put Options: Why Short a Stock when You Can Buy a Put? For more on naked options, read Smart Profits #129, Covered Calls and Puts: How to Grow Your Equity By Going Naked.
  • Check out the Smart Profits Glossary for more information on “naked puts” or “limit orders.”

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2005 | Leave a Comment 

Technical Indicators

February 9, 2005

The Smart Profits Report: Issue #183
Wednesday, February 9, 2005

Technical Indicators: How to Overcome the “Evil Twins of Trading”
By Mt. Vernon Research Team
Mt. Vernon Research

I don’t care how much I know, how long I’ve been doing it, or how well I’ve done it, there’s always something more I can add in options. Some way to improve. Every performance is a potential lesson, and it is the trades that go wrong that have taught me the most.

I’ve mentioned before that I write down why I make every trade. What technical indicators I followed… what news or fundamentals attracted me… what the chart was showing at the time… what I expect the stock to do…where I should get out…

When I looked at my misses a few years ago, I found I did better in trending markets. My trading took a huge leap when I realized that was a weakness in my system and worked on some additional strategies to handle it.

You may not have that problem. But I will bet you have my other weakness… or its evil twin… That would be jumping in too early, or waiting too long to pull the trigger.

If you identify and root out these two timing problems, you can increase your overall returns by 10% this year - and individual returns by as much as 50%. Let me explain…

Get Ready, Get Set, Get Back

Most technical indicators catch trends after they’ve begun. Even simple chart reading. You can’t tell a stock has bottomed, for instance, until it rises off the bottom. So whatever system you use, you don’t get 100% of a stock’s rise as a rule. You get 70%-80% of the move if you act as soon as you get your signal.

Naturally, I figured I could improve on that. Especially when my big idea was based on a stock I liked as an investment that was getting into a strong trend. Or when I saw one of the overpriced trash stocks take a dip. Or when I read a news item that sparked a brilliant insight.

Once upon a time, I was the kind of trader who would read a story on paper shortages and assume Kimberly Clark calls would be a great trade. Paper and Forestry stocks were bound to go up, right? When I got a little more sophisticated, I started timing my trades better with technical indicators.

Tweak Your System With Technical Indicators - But Never Cheat It

Now I had the right tools, but I misused them too often. I still jumped too soon. I didn’t want a trade to “get away.” If I was waiting for a stock to go above $42 to give me a breakout signal, I’d trade it when it got to $41.75. And I’d never wait for a pullback, which would give me a better risk-to-reward potential. It might not pull back. I’d miss it!

If I were waiting for a MACD (Moving Average Convergence Divergence) cross - a classic technical indicator - I’d open up my trade when the lines had almost crossed. I mean, what’s a little daylight between lines? Everything was already headed my way… the train was on the track, why wait?

Why an Early Start Is Twice as Hard

All the standard technical systems are based on lots of data or strict formulas, and most of them work either directly or indirectly with support and resistance levels. It is hard for a stock to move through support or resistance. What happens when you get in just a little too early is that you set up right at the most difficult possible place. The stock that rose to $41.75 wouldn’t go right to $42. It would drop back on me, then try again, then again. By the time it finally crossed the $42 line - if it ever did - I’d wasted a lot of time value on my option.

If you are trading short-term options, you should be doing some chart reading. Technical systems are necessary to help you out. They can range from the very simple (such as looking for a strong trend with good volume) to the complex sets of indicators that I use.

But learning to wait until the prime moment when your system is really where it should be - not headed that way, really there - will probably add 10 percentage points to your average just like that.

And if you aren’t the type who bolts out of the gate too fast, look at your misses - or better yet, the trades you almost made but didn’t - and see if you have the exact opposite fault: “analysis paralysis.” The evil twin of jumping in too soon is waiting too long.

Just One More Little Thing

Oddly enough, it’s possible to suffer both weaknesses.

I know. My old trading books are full of symbols I’ve written down with three check marks beside them. That’s my code for a stock that’s supremely ready to trade. Except that I didn’t. Oh the 100%-ers I’ve missed waiting too long…

Both faults - moving early or waiting too long - trace back to confidence. Trading too soon happens when you’re overconfident. Particularly when you’ve had a string of wins. Waiting too long happens when you are feeling skittish and it’s apt to sneak into your repertoire when you’ve just had a loss.

As I have said before, if you are getting 50/50 results with your options trades, you are doing quite a lot right already. You only need to improve one or two little faults to turn that into a winning record.

Good Trading,

Mt. Vernon Research Team

Sign Up for The Smart Profits e-Report!

Today’s Smart Profits Cribsheet

  • Check out the Smart Profits Glossary for definitions of words like “indicator” and “resistance” found in today’s article.

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2005 | Leave a Comment 

Basic Trading Rules

February 2, 2005

The Smart Profits Report: Issue #181
Wednesday, February 2, 2005

Basic Trading Rules: The Four Rules of All “Smart Money”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research

As I was escorted to my daughter’s classroom for a fifth-grade “Career Day” presentation, one of my little handlers asked me if I “got nervous” before a speech. I said yes. He asked if it was the same kind of “nervous” as the competitors on the reality show Fear Factor experience. “I don’t watch the show,” I said… adding: “You watch Fear Factor? Aren’t you kind of young for that?”

Within seconds I was standing in front of the class, beginning my presentation, a little more nervous than I otherwise would have been…

So what does all this have to do with options trading, exactly? Nothing. Except for the fact that four of the most important rules about money are so simple, even fifth-graders can understand them.

Yet, they’re so powerful - and so basic to smart investing - that every trader should memorize and follow these four basic trading rules before trading a single option.

Let me explain…

The Four Basic Trading Rules

My goal for the class was to try and teach kids the four rules regarding money that I would encourage anyone to memorize before trading options. Now, I know from experience that even adults have a hard time learning just one thing in 30 minutes. And, when it comes to managing money - it might never make any sense.

I chose four things that I believe are the most important rules of dealing with money… rules that you may want to share with your kids or other loved ones, regardless of their age.

Rule #1) Go with moderation over excess…

I started with moderation versus excess - something a kid can understand and adults often forget.

The first example I gave the kids was the “need” for everyone to buy the biggest car with the worst mileage just to get from point A to point B. To an environmentalist, that’s excessive consumption: End of story.

I don’t go that far, but to a “money person” it’s excessive spending, especially for those who have trouble making car payments. (I also used the Halloween tummy-ache example - go overboard with the candy, and you pay…)

Moderation versus excess affects our future ability to achieve financial independence… To a fifth grader this means being able to buy another video for his Game Boy. To the options trader, it is spending a lot of money chasing hot short-term trades without a system (most of which go bust) instead of focusing on high-probability trades like the LEAPS options.

Rule #2) Stay on the right side of compounding…

Second, I talked about compounding. The example I used here was a kid who got a dollar a day and spent it on candy and the kid who put the money (some of it, at least) in the bank. At the end of the year, I explained that Child A would not only have no money, but also lots of cavities. Child B would have all the money he saved, plus something extra for “lending” the money to the bank. I was quite impressed by how many kids actually knew that banks loaned out people’s savings at higher rates - I know I did not know that at age 10.

Rule #3) Use credit; don’t let it use you…

Third, I talked about credit. I explained good credit (buying a house) and bad credit (spending money at a restaurant and paying for it six months later). I tried to impress upon them that spending more than you can afford would likely result in a sad retirement.

I told them that they would be getting offers for credit cards in the mail once they were in their senior year of high-school. My advice: Tear up the envelope before you open it. I also explained that if they did not know how to manage credit, they could spend 30 years paying for video games that may only be played for a year. The video game themes resonated well with this crowd.

Rule #4) Always own some tangible assets…

Finally, I brought in 450 one-dollar bills and an ounce of gold. I asked the group which they though is worth more. They all pointed to the currency. I tried to explain fiat money and what tangible assets were.

I think I lost them on this one. But, there were a lot of oohs and aahs when they saw the stack of bills. (My favorite response from one girl who picked the gold coin was, “It’s worth more because it is so shiny.” Almost right…)

The day was quite a success and I enjoyed the Q&A. I encourage you to talk to your kids and grandkids often about money and investing. It could be one of the best early childhood lessons that you could impart to them.

And if they want to follow you into the options market someday - and win - they’ll need to know these basics first.

Good trading,

Karim Rahemtulla

Sign Up for The Smart Profits e-Report!

Today’s Smart Profits Cribsheet

  • Ever wonder what a chameleon option is? Click on over to the Smart Profits Glossary, chock full of over 150 option terms!
  • If you don’t know how to manage your money, you won’t be in the game long. This is especially true for options trading because of the inherent time limitations. Not only do you have to decide on the strike price, but also on the expiration date. It’s also important to know how much money to put at risk. For more on option trading, check out Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run.

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2005 | Leave a Comment