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Market Volatility
The Smart Profits Report: Issue #107
Monday, May 3, 2004
Market Volatility: How to Pay $27 for a $50 Stock
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Repeat after me: Market Volatility is my friend.
Time is an important factor in options trading, as we’ve already seen. After all, what good is being right if you run out of time? But almost as important as time is volatility.
Volatility is the measure of how much the underlying stock or commodity moves in a given time. The more volatile the underlying instrument, the more volatile the option will be as well. And the more expensive…
Let me explain why that’s not such a bad thing…
You Pay More for a Race Horse than a Plow Horse
In researching my covered call strategy, one company I looked at was General Electric. This old stalwart of the Dow was growing its profits about 12% a year. Its share price moved in a $10 range in any given 12-month period. When GE was trading at $30, the $35 call option with a 1-year expiration was trading for $3 per share - about 10% of the stock’s current price.
That meant it would cost you $3 for the option and another $35 (the strike price on the call) to buy GE if you decided to exercise your option - or a real cost of $38 a share. And remember, GE at $30 was only likely to go to $40 within an average year.
Now, compare this to Amazon.com. Amazon was trading at a split-adjusted $13 per share. In a 12-month period, the shares moved from $13 to $110. The $20 option (which was far out of the money and should have been “cheap”) on Amazon with a 1-year expiration would have cost about $7 - over 50% of the stock price, versus 10% in the GE example. That’s a ratio of 5 to 1.
The huge difference was solely due to volatility. You weren’t especially likely to make big money trading GE options, but with Amazon’s volatility, lightening could strike.
With Amazon, you might easily have paid the $7 option premium, then exercised at $20 for a total cost of $27. Of course that $27 would have bought a stock that was going for $40, $50 or more on the market. Makes the high premium on Amazon look a lot different, doesn’t it?
Market Volatility Makes Them Expensive for a Reason…
Volatility is an important indicator to add to your analysis arsenal. Many investors get turned off by high-priced options. They want the low 50-cent options, thinking a little investment will make them big returns.
But when an option is cheap, the options market is actually telling you that it doesn’t think much of your chances. You are less likely to make money on a 50-cent option than you are on a $5 option.
How can you know this? You can check for yourself. This effect wasn’t limited to the high days of the Internet bubble. These disparities are in the market every day. Compare at-the-money options on some stocks selling for the same prices today. For instance, Exxon, Computer Sciences and Amazon are all selling around $40 now. But if you wanted a January 2005 call at $40 on them, you’d find the prices much different. You’d pay 4.20 for Exxon calls, about 5.10 for Computer Sciences, and 8.70 for Amazon.
Which one do you think is going to make a big move? Even now, Amazon is still able to move up or down more than $30 in a year. Computer Sciences may move up or down $10… and Exxon is lucky if it makes a $4 move.
The most expensive option (and they are all at-the-money options for stocks at the same price with the same time to run) is Amazon’s because it reflects the ABILITY of Amazon’s shares to make a big move. The better this ability, the more you will pay to play this game.
Price = Volatility = Potential… All Else Being Equal
Expensive options usually have high potential. That’s why I give them serious consideration when I find them on a company that interests me.
A good example is Research in Motion (Nasdaq: RIMM), the maker of the handheld Blackberry communications device. Recently, I told my readers that this company was a good short, meaning I thought it was likely to fall in price. Over the past year, speculators gone wild had pushed the share price from $13 to $100 before it seemed ready to turn down. When RIMM was back down to $95, I recommended a put option with a $90 strike price that would expire in June. It was trading at 6.70.
Two days later RIMM was down to $87 - and that put option went to 11, a 64% gain in two days on an 8% move in the share price. You aren’t likely to see that with a cheap Exxon option.
So, while the RIMM option was expensive, it was also one that produced significant profits on a relatively small move in share price. RIMM has a history of moving up or down 10% in any given week. That volatility is transferred into the options price.
Don’t turn away automatically when you find an option is expensive. Instead, explore why it is “expensive.” More often than not, you will find that the higher price is worth the investment.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Visit our Smart Profits Glossary to learn more about options trading terms like “volatility” or “strike price.”
- For more on the two types of volatility within options, mainly historical and implied volatility, check out Smart Profits #186, Option Volatility: A Free Tool For Finding The Best Option Bargains.
Related Articles:
- Understanding Options Risk: How to Beat the “Volatility Premium” on Options
- Implied Volatility: The Impact of Beta on Your Option Positions
- Using a Probability Calculator: Know Your Trade’s Exact Chance of Success Up Front
- Fast and Furious Volatility is Back in a Big Way: How To Profit Using Leg Spreads & The VIX
