From the Top

Are the Options Premiums You're Paying Worth It?

How implied volatility can impact the success of an options trader

by 2/4/2013 10:47 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the February edition of the Option Advisor, published on Jan. 24. Prices and the chart are as of the close on Jan. 24. For more information or to subscribe to the Option Advisor, click here.

"You can't always get what you want
But if you try sometimes, you just might find
You get what you need"
"You Can't Always Get What You Want," Rolling Stones, 1969

"Come, Mister tally man, tally me banana"
"Day-O (The Banana Boat Song)," as performed in Geffen Film's "Beetlejuice," 1988

One of the trickier aspects of options trading is deciding if the forecast for future volatility embedded in the option premium you are purchasing (the so-called "implied volatility") is reasonable. If the volatility over the course of the holding period for your option proves to be lower than implied volatility, it can be said in retrospect that the premium you paid was "rich." And the opposite can be said about your purchase price, if this future volatility proves to be greater than expected. But is this really where the key to your success as an options trader resides?

To address this question, let's assume the volatility over the period you own an at-the-money call proves to be twice that which was anticipated in the premium you paid. So how much money will you make? (Note: trick question)

The answer boils down to the following: You have a 50% chance of losing your entire premium at expiration on any at-the-money option you buy if you get the direction wrong, regardless of your cost and regardless of the level of stock volatility over the holding period. Okay, you say, let's assume I get the direction right and buy a call and the stock finishes higher than my strike at expiration. And to this I would say: The expected value of your call at expiration in this instance is twice the premium you paid, due to the fact that share volatility was double what had been expected. But this still does not guarantee you a profit at expiration – the stock must finish above the level of the strike price plus the premium (albeit cheap premium) you paid.

In other words, the expected value of your at-the-money call reflects a weighted average of all the possible prices at which the stock may be trading on expiration day, based on long-standing statistical methods. So even if you "know" the future volatility for your stock, all you really know is a range of possible prices for your at-the-money option at expiration. Such knowledge gives you no information at all about the direction or the magnitude of this future price movement. And no matter how high this future volatility, you as an at-the-money call buyer still stand a 50-50 chance of experiencing a 100% loss by being wrong on the direction.

The bottom line is when you buy call or put options in order to leverage your price forecast for a stock over a defined time period, the "unit of currency" for your purchase price is volatility, but your payoff is in an entirely different currency – the extent of the price movement in your forecast direction. You may think you want high volatility, but what you really need is big movement in your forecast direction - the only "tally" of importance for winning this game.

But there is even more to this dichotomy between paying for volatility but ultimately getting paid in directional movement, as very often your volatility-based cost will be at its lowest when your desired directional movement is at its greatest. And an excellent illustration of this "best of all worlds for option buyers" is found in the accompanying daily price chart of Visa (NYSE:V) (along with its 14-day historical volatility (HV)), since post-IPO trading began on March 28, 2008.

Daily

After an initial rally to about $90 from the mid-60s, Visa shares declined sharply over the next six months to the $40 area, whereupon a rally over the next year or so terminated just shy of the $100 mark. It was not until late 2011 that Visa mounted another serious assault on $100, and by February 2012 the $100 level was firmly in the rear-view mirror (the shares reached an all-time high at $162.77 earlier this month). But whither the volatility of Visa shares over this one-year period of very powerful upside price action? Taking a look at the lower panel of the chart that displays 14-day historical volatility (HV) -- and ignoring the unusual volatility associated with periods around earnings reports -- we note that 14-day HV peaked at 36% at the beginning of December 2011 when the shares were first mounting their attack on the $100 level. But by the time Visa had rallied by about 20% to $119 in March 2012, 14-day HV was more than cut in half to 15%. And by September 2012 with the shares at $128, 14-day HV reached a nadir just shy of 10% and then proceeded to bottom at 8% with Visa at $148 in December. At Visa's close of $159.56 today, its 14-day HV finished at 10.47%, which leaves us with the following tally: Visa shares +59% (since December 2011) and Visa's 14-day historical volatility -70% from 36% to 10.47%. (While implied volatility (IV) for Visa options did not decline to this same extent over this period -- IV dropped from 30% to just below 20% -- the cost to purchase Visa options was still dramatically reduced.)

So can you as an options trader have the "cake" of strong price action and eat it, too -- by paying progressively lower call option premiums? You bet -- just make sure your bets are bullish over such periods!


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