Sponsored Link:
Understanding Options Risk
The Smart Profits Report: Issue #188
Thursday, March 3, 2005
Understanding Options Risk: How to Beat the "Volatility Premium" on Options
By Mt. Vernon Research Team
They say politics makes strange bedfellows, but investing makes stranger ones. At one end, you have the dry-bones academics who objectively juggle information and compute theories. At the other, you have sweaty everyday people who invest knowing nothing of the theory and often don’t behave like they should.
Alongside them are the every-day-in-the-market sharks. The big-money guys, professional traders and other adepts. Theory, they say? It’s just a tool, and they make their money punching holes in it.
Consider the theory of risk. Understanding options risk is central to knowing how to make money trading them.
Academics and market makers understand it alike, but each treats it differently. And, as we’ll see, most amateurs look at it backward.
The Book-Learning Definition of Risk
Let’s pick up with the book-learning definition. Academics most commonly define risk by "beta," a kind of volatility. Beta measures how much the stock moves compared to the overall market. So a beta volatility of 1.0 is about equal to the S&P 500, and .5 is half as mobile.
That’s stocks. In options formulas, volatility is translated in terms of comparing the stock price to itself rather than the market.
When you see a volatility quote of 28% on the Chicago Board of Options Exchange or other options sites, that means the movement in the stock is the equivalent of a normal 28% range either way in the price over a year’s time. It’s based on a formula for calculating the standard deviation over 60 days, then annualizing the result.
Be that as it may, high-beta stocks usually beget high-volatility options. And if beta equals risk, wouldn’t you assume the same for options volatility?
Where do you stand on the issue? Would you side with the academics and say that high-beta Applied Materials is riskier than low-beta Safeway? Let’s get more specific.
Just 18… And Going Places
Both Safeway and Applied Materials stocks were at $18 recently. The prices go up and down, but so far this year, the weekly variation for Applied Materials often exceeds $1. Not so for Safeway, which would count a 50-cent week as a big move. Applied Materials has a beta of 2.5; Safeway’s is only 0.7.
Clearly, Safeway is a much safer stock in academic theory. Actually, for investors, both have been lousy, but Safeway has lost less in the past five years than Applied Materials. Then again, it has lost more in the last year. Still, with a low beta, academics would consider Safeway a safer stock.
Safety Is Risky In Options
Options market makers disagree violently. Remember, they never give anyone a break on purpose. If they see any value in an option, any chance it will pay off, they charge for it.
So with both stocks at $18, let’s compare the prices on the $20-strike April options. Since the stocks may go either way, we’ll consider a straddle for each. That would be one put and one call at $20.
Safe old Safeway had cheap options recently. A full straddle cost 2.00 (.20 for the call and 1.80 for the put).
For Applied Materials, an April 20 straddle cost 2.95 (.10 for the call and 2.85 for the put). That’s almost 50% more than the price for Safeway straddles. Blame it on beta and volatility - everything else was equal.
Do you think the market maker got it wrong, charging more for the weaker investment? Not a chance. That’s what I meant when I said most amateurs look at it backward.
Historical vs. Implied Volatility
He sold the Safeway calls at a price that reflected a 35% volatility, which is very close to the stock’s historical volatility of 31%. The historical volatility is based on real data. It’s objective. The implied volatility isn’t. The market maker estimates the likelihood that the stock will move far enough to cost him money… and that is his measure of implied volatility.
But the difference between reality and market price is pronounced with Applied Materials. Its actual, historical volatility is 28%. Yet the market maker charged an implied volatility of 50% on the puts. He sold the calls at the historical level, no extra.
So which options are safer?
People who know that high volatility is supposed to mean high risk would usually guess Safeway was the safer option, because the market maker charged a much lower implied volatility.
How to Beat the "Volatility Premium"
But the market maker isn’t worried about YOU. He’s worried about himself. He ups the implied volatility when he needs a bigger premium because he’s more likely to get caught having to pay off. High volatility is risky - to him. Given two stocks at $18, the more volatile one is more likely to hit $20.
In other words, lower volatilities are not safer for you - the market maker thinks they’re safe for HIM. But that’s still an incomplete answer. You still don’t want to pay too much for volatility… and that’s what the market maker is always trying to make you do.
The way to make money is to choose an option on a stock that will move even more than the market maker expected. That’s how you beat the volatility premium, and it takes some technical experience to find these plays routinely.
But It Can Pay Off Handsomely…
Last week, for instance, Optionist traders took calls on UPS, a stock with a tiny beta of 0.47, meaning it typically moves less than half as much as the market. CBOE’s historical volatility for this stock is also extremely low, just 12.5%.
But my system spotted a move building, and we bought a UPS April $75 call at 2.25 on Feb. 2 when the stock was right at $75. It had just had a huge drop a couple of weeks earlier, and I saw that it was about to make a strong move back upward. The market maker wasn’t thinking that. He sold the option with an implied volatility of around 15% - even after all the recent uproar in the stock.
Two weeks later, UPS made a big move from $75 to $79, and we took a 91% gain.
Most cheap options - the low-implied-volatility ones - don’t pay off. But when you can spot a quiet stock about to make an unexpected move, they pay off best of all.
Good trading,
Mt. Vernon Research
|
Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions like "beta" or "historical volatility."
- For more information on what beta or implied volatility is within options, check out Smart Profits #245, Implied Volatility: The Impact of Beta on Your Open Positions.
- Ethanol, ethanol, ethanol, the hottest topic since solar energy. In the Smart Profits Report Forum, Ethanol Investing, four out of five of our editors give their take on what the rising costs of crude oil will unfold for ethanol production and how you can profit from it.
Related Articles:
- Game Theory - Making Profits With Mathematical Precision
- Warren Buffett’s Investing Strategy: The Master of the "Buy and Hold"
- Investing In The Water Market: Turn Water Investments Into Profits From This Looming Global Crisis
