The price of an options contract is the market’s best guess about future volatility, which translates into how much the underlying stock price is expected to vary from its current price over the life of the option. Most options traders fail to understand this premise, which is why so few clients trade options successfully.
Most clients simply buy call options if they’re bullish or put options if they’re bearish. But being right about the direction will not result in a profitable trade if you overpay to enter the game. Most options traders lose money over time, which speaks to the importance of this very basic premise.
The problem is clients have only a rudimentary understanding of “volatility” and have no concept whether volatility is overstated or understated at a point in time. So, if at-the-money options on Goldcorp Inc. are trading at an implied volatility of 39%, is that good or bad? Without a point of reference, it is impossible to know.
The options premium effectively handicaps the underlying market, much like the spread handicaps the wager in a football game. If I were making a bet on the outcome of a football game, and Team A with a 10-2 win/loss record was playing Team B with a 2-10 record, I would expect Team A to win the game. But if we were to make a bet on the game and the spread was a Team A win by 60 points, this would change my view of the outcome – as it’s highly unlikely any professional team would beat another by more than 60 points.
When we make investment decisions, we follow much of this same process. We make a decision to buy or sell based on technical chart patterns or fundamental analysis. If your clients were buying the underlying shares, there’s no timeline to worry about. In that instance, using some historical metric to make the decision is valid. But once your client uses options to engage in a strategy, an assessment of the handicap is critical.
There lies the problem: although we know a 60-point spread in a football game is excessive, we don’t have the same intuitive feeling about implied volatility. To deal with this, we need to translate implied volatility into an implied trading range. For example, at the time of writing, Goldcorp was trading at $25 a share. Both the three-month $25 (strike price) calls and puts were trading at $1.95.
Purchasing both calls and puts (known as a “straddle”) would cost your client $3.90 a share. At this point, your client is long a call and a put on Goldcorp and is no longer concerned about direction. The call profits if the stock price rises; the put profits if the stock price declines. To profit, the underlying stock price has to move by more than the cost of both options.
What we have, then, is a three-month implied trading range for Goldcorp calculated by adding and subtracting the total cost of the two options from the strike price of the underlying stock. The top end of the range is $28.90 ($25 + $3.90 = $28.90); the bottom end, $21.10 ($25 – $3.90 = $21.10).
If your client believes Goldcorp is likely to breach either end of this trading range over the next three months, the options are undervalued. This would suggest two options strategies: buying calls if bullish or puts if bearish.
If your client believes Goldcorp is unlikely to move beyond this range, then the options are overstating future volatility (i.e., overvalued), which makes options-writing strategies more attractive. Covered calls or uncovered puts, if the client is bullish; or uncovered calls or a “bear” call or put spread if the client is bearish.
Assessing the options market’s best guess about future volatility – as set out in the implied trading range – determines the best strategy to profit from the underlying stock’s expected price move.
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