Early in may, a company that we will call XYZ closed at $50 a share. At that price, the shares had moved sharply higher intraday on heavy volume. In fact, in this hypothetical example, the shares were up more than 100% over a short period of time. The intraday movement on this May day was the culmination of a month of activity. Technicians refer to this latest move as a classic “blow-off.”
What made this all happen? Perhaps a merger, maybe some startling news about a new drug — the same reasons we see driving stocks all the time. Pick the one you are most comfortable with for our hypothetical stock.
The reason for this illustration comes back to strategy selection. Allow me to put some numbers on the XYZ options. Let’s assume that the XYZ August 25 puts, with three months to expiry, are at $1.75 a share. (For the record, put options rise when the value of the underlying stock declines.) These puts are $25 out of the money, with less than three months to expiry. The volatility implied by these hypothetical puts is 185%.
What we have then is a stock with a classic blow-off techni-cal pattern, and options at the extreme end of the volatility curve. Eight days later, our hypothetical stock plummets to $35 a share, down 33%. The XYZ August 25 puts are trading at $1.50 a share. I trust you see the problem.
Had you purchased the XYZ August 25 puts, you would have watched the stock fall 33% over a short period of time and yet still watched your potential profits evaporate. Theoretically, they should have increased as the underlying stock price fell. The reverse happened because the volatility that was embedded in the options evaporated.
What this hypothetical example demonstrates is the importance of strategy selection when using options to play your view on the underlying stock. It also serves to explain why technical analysts, without having proficiency in options pricing mechanics, tend to have problems making profitable trades in the options market. It isn’t just about making decisions as to what this or that stock will do over the course of time. You have to implement the correct options strategy to take advantage of the situation.
Simply stated, buying options is not as easy as just buying calls because you think the stock will rise or buying puts because you think it will decline. The price you pay to buy these instruments has as much to do with making profitable decisions as your decision as to which direction the underlying stock is about to move.
Think of options strategy selection as placing a wager on a football game, bearing in mind that gambling and options trading are not inexorably linked.
Suppose you have the San Francisco 49ers playing the Chicago Bears in the eleventh week of the football season. Over the previous 10 weeks, San Francisco has won nine and lost one, while Chicago has lost nine and won one. Based on the year-to-date performance of the two teams, you would expect San Francisco to win the game.
But to make money on that decision, you have to make a wager. And since most observers have probably come to the same conclusion, no one will take the other side of that wager unless you are willing to pay a handicap.
What if the handicap was 50 points? That would likely change your outlook on the game. While you still may think San Francisco will win, now the team has to win by more than 50 points for you to profit from that decision — probably too much to ask.
In the same way, the options market handicaps the underlying stock market by making you pay a premium to play the game. If you pay too much for the premium — like the 50-point spread in our football analogy — you won’t make a profit even though the stock may move in the direction you expected.
Understanding the handicap is what strategy selection is all about. Problem is: the options pricing formula makes it difficult to know intuitively whether the option premium is too high or too low.
Whereas most of us know that it is highly unlikely that any NFL football team will beat another NFL team by 50 points, it is not as easy to quantify whether $1.75 per share was too much to pay for an XYZ August 25 put — with three months to expiration — when the stock is at $50 per share.
@page_break@One thing that makes football handicapping somewhat intuitive is the notion that we have clearly defined objectives. Two teams are playing. We think one will win. And we have a feel for handicaps that are over the top. More to the point, once the wager is placed, winning and losing is determined only after the game is over. We can’t re-examine our position at halftime and alter the wager.
Perhaps if we apply that same logic to the options market, it will help us evaluate in a more straightforward manner whether an option premium is reasonable.
One approach that might help investors become more intuitive is to re-examine the strategy based on some of the more obscure calculations that are fed from the options pricing model. For example, the “delta” tells us how much the option should move, given a US$1 move in the underlying stock. The XYZ August 25 put had a delta of 0.10 when the stock was at $50.
On the surface, you would expect the XYZ August 25 put to rise 10¢ for every $1 decline in the price of the stock. In theory, then, the August 25 puts should have gone from $1.75 to $3.25 (an increase of $1.50) based on the $15 decline in the underlying stock. Of course, theory doesn’t always hold up in the real world.
To understand what happened in our hypothetical case, we need to go back to the XYZ put’s pricing formula. We want to examine some of the other derivatives from the formula.
The “theta,” for example, is one derivative in the pricing formula. It tells us how much the option’s price is expected to decline as it gets closer to expiration. The seven-day theta tells us how much of a decline is expected over the next seven days.
In the XYZ example, the August 25 put had a seven-day theta of 0.397 in late May, which means that we would expect the put’s price to decline by 39.7¢ over the next seven days. We’ll call it 45¢ over an eight-day period. Traders lose 45¢ of a potential $1.50 profit simply because of time value erosion.
The other problem was the initial cost of the put in late May. The put was being priced at 185% volatility. One week later, it was trading with an implied volatility of 140%. Another derivative in the formula — called the “vega” — tells us how much an option’s price will decline based on changes in the volatility assumption. In this example, the put would lose 3¢ for every 1% decline in volatility. That takes another $1.35 off the option price.
Bottom line: the changes in the volatility assumption and the time to expiration had more impact on the put’s price than did the movement of the underlying stock. There was no profit despite the fact you were right about the underlying stock. It’s like San Francisco won the game, but not by 50 points.
The solution in this case was to have chosen a different strategy. If the options are overpriced, look at an option writing strategy rather than simply buying a call or put.
Knowing what a stock is likely to do, or which team is likely to win, is not enough. In the options business, as with football wagering, you have to evaluate the handicap. IE