Tuesday, October 14, 2008

Options & Volatility: What it Means to You

My financial inbox is a repository for every single piece of spam spanning the entire marketplace. Every time I up the spam filter I lose crucial email. I just can't win, but being the eternal optimist, I occasionally read the spam, if nothing more than for entertainment value.

But lately, some of this spam has been more disconcerting than entertaining, especially in the options arena. Now, dear reader, if you're not into options nor do you ever intend to be, then don't read on. But if you do play options, it would behoove you to stay tuned 'cause I've got some important information that's timely to today's market.

Long Straddles and Strangles
No, this isn't a sequel to Blazing Saddles, but rather two options plays that have been papering my inbox from various financial entities who want to ultimately sell me their product. You might already be familiar with the concept of a straddle since I introduced it in my second recipe, Straddle Strudel. To recap, a straddle is an options play where you buy an equal number of calls and puts with the same strike price and the same expiration date. A strangle is the same except the strike prices are different. This lowers the cost to put on the trade but it also widens the break-even points.

These options strategies are used to take advantage of volatile markets or special events where the underlying could move dramatically in either direction—you just don't know which direction it'll be. You're probably thinking, "Hey great! This would be an excellent play in the current market." You along with a lot of other folks, including the CBOE. On the surface it does seem like a good play, so what's my beef? It's the volatility itself.

Options and volatility
In just the past month, market volatility (as measured by a basket of options on the S&P 500) has more than doubled and is currently hanging out at unprecedented levels. A high volatility means that options premiums are more expensive, although the implied volatilities for each stock (and for each month and strike price, for that matter) are different. What this all means is that a straddle put on today might cost considerably more than one put on a day or two from now (or vice versa). To drive home my point, let's consider an example that I calculated from data taken earlier today.

Example: A long straddle on the Diamonds
This morning the Dow tracking stock, the DIA, was trading at $94. At that time, the cost of putting on a March 95 straddle would have cost about $17.45 per contract. This means that in order just to break even, the stock would have to trade either above $112.75 or below $77.55. Not that either goal is impossible; it's just that the probability of either event is fairly low. But if we put on such a strategy when the implied volatility (IV) is lower, our breakeven points are narrowed and the probability that we'll make money on the trade increases. To see the effect that IV has on the price of options, I've complied the chart below by plugging in different IV values into my handy-dandy Black-Scholes options pricing calculator at a constant stock price of $94. (Click on the table for a larger view.)

These results should shock you. You can see that as volatility decreases, the difference in the price of the same option decreases dramatically, especially for calls.

The moral of the story
The moral of the story is to do your options due diligence before you even think of placing a trade. You should do this every time anyway, but it's especially important with these types of trades because the outcome is so dependent on IV. I know you're getting tired of hearing my admonitions, but please please please, do yourself a favor and paper trade these complex strategies first. There's a lot more to them than how they are being hawked in the financial spam letters which makes these sound like simplicity itself. Don't fall for it!

Resource: The CBOE (link to the right) gives historical implied volatility data for any optionable stock or ETF. Click on the Tools Tab and then the IV Index.

No comments: