Indicator of the Week: The Best Stocks for Option Traders

Stock and option trading are two very different things

Senior Quantitative Analyst
Jun 1, 2016 at 7:26 AM
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Here at Schaeffer's Investment Research, we specialize in option trading. Though an option contract's value is based off the stock price, a stock picker is not necessarily going to be a good options trader. The main difference is that options have expiration dates. Therefore, an option trader not only has to be right on direction, but he has to get the move within a specified time frame. 

Two more things that must be considered by option traders which stock traders do not deal with are the strike price of the option and implied volatility of the option. These features make option trading a completely different animal from stock trading. Stocks are often compared by simply how much they return over a certain time period, but impressive stock returns do not necessarily correlate into great option trades. This week, I’ll give an example where stock and option returns diverged, and I’ll also give a list of some of the best stocks for trading options over the past year.

Comparing STZ & W Option Returns: Below is a chart showing stock returns for Constellation Brands, Inc. (NYSE:STZ) and Wayfair Inc (NYSE:W) over the past year. Both stocks have done very well with W outgaining STZ. But have these stocks been kind to short-term option players? That's what option traders like us want to know. 

STZ and W stock returns

So, let's consider a short-term option trader who typically holds a position for one month. How did these stocks fare for him? To evaluate this, I assumed a trader could purchase a one-month option on the stock every single day. I also assumed he bought a strike price that was exactly 5% in the money (ITM). To find the prices of these hypothetical options you need an implied volatility. To get these, I looked at the near-term options which were about 5% ITM and used those implied volatilities for my hypothetical options. Furthermore, I assumed the trader held them the entire month and closed them out at intrinsic value when they expired.

So, how would a trader have done with these two stocks had he purchased one of these hypothetical call options every single day over the past year? The table below summarizes his results and many will find the results awfully surprising. Notice that even though W outpaced STZ during the time frame, buying calls on W would have resulted in a loss of 3.7% per trade while STZ call options would have gained about 22% per trade.

The percentage of positive trades is pretty revealing, as well. For STZ, without doing any analysis of the stock, but randomly picking a day to purchase a one-month call option, there was a 66% chance of that option being profitable. For W, the chance of a profitable call trade was just over half that, at 38%.

STZ and W hypothetical call returns

How did this happen? Why is STZ such a superior stock for buying options compared to W, which had a better stock return over the time frame considered? There are two reasons that stand out.  

First, option traders have expiration dates. Notice how choppy the W returns are compared to STZ. While Wayfair gained over 40% over the past year, when you slice the chart down into one-month time frames, the down periods or sideways periods are probably as prevalent as the up periods. Buying a call option during these times is a losing trade. In contrast, the STZ chart has a much steadier uptrend over the past year.

Second, the implied volatilities on W are much higher than STZ. To see just how important implied volatilities are for options traders, take a look at this example using current stock and option prices (as of midday on Tuesday, May 31).

With STZ trading at $153.12, to buy the 145-strike (about 5% in-the-money) call option that expires Friday, June 17, it would cost $9.20. The implied volatility of this option is about 29%. A stock move of 2.5% would put the stock at $156.95. The intrinsic value on the 145-strike call would be $11.95, which means the call option gained almost 30%.

On the other hand, W was trading at $40.54, and buying the 38.50-strike call option (5% in-the-money) that expires Friday, June 17, cost $3.10. A 2.5% move in this stock puts the price at $41.55, so the intrinsic value on the call option is $3.05. Therefore, this option actually lost 1.5%. 

Do you see how big of a difference the returns are? Buying a call option 5% ITM on these stocks and then assuming a 2.5% stock gain over the next three weeks yields about a 30% return for the STZ call option, but a 1.5% loss for the W call option!  The dichotomy is due to the implied volatilities of the options. Below is a summary of the example.

STZ and W hypothetical option return

Does this mean STZ was a superior stock for option traders? Not necessarily. What if a certain trader was extremely talented at perfectly timing the stock moves? If a trader is that good at timing, then he may choose to play options on W because of the outsized gains he can achieve on those major moves. 

Notice in the table comparing the option returns, the second-to-last column shows the percentage of time the options would have doubled in value. Randomly buying a W option could have given a 100% winner 18% of the time, while options on STZ doubled only 9.9% of the time. So, a trader especially good at timing big moves might be better at trading W than STZ. 

The last column shows the number of crap outs. A crap out is when the stock fell by 5% or more, meaning the hypothetical option purchased finished out of the money and, therefore, the trader lost his entire premium. Note that an option trader had about a 1-in-3 chance at losing his entire premium when buying W options, compared to a chance of less than 5% when buying call options on STZ.

Best Stocks for Option Traders: Using the same type of analysis above, there are many ways we can use the data to search for ideal option plays. It depends on what a trader is looking for. Some may look for stocks that have a lot of big winners. He might want to look at stocks with a high percent chance to double. Another trader may look for the best average call return. In the tables below, I looked for stocks that gave the option trader the best chance at making a profit (percent positive). 

Just to reiterate, the analysis assumes you can purchase a one-month option that is 5% in-the-money. It assumes you purchased one of these every single day over the past year, and it summarizes the results.

The first table below shows which stocks gave an option trader the best chance at making a profit. Notice STZ, which we talked about already, is at the top of the table.  It’s interesting to see the differences in some of the other fields. NVDA is interesting with a massive 107% stock move and an average call option return of 52%. Also, those options doubled 36% of the time, but it was still a very risky play, showing an almost 20% chance of losing your entire investment. 

Best stocks for option traders

Those were good stocks for buying call options. What about bearish put traders? Below are the stocks that had the best chance of making a profit using the same analysis as above, but instead of buying call options, the trader bought put options that were 5% in the money. Returns on these poorly performing stocks are much more volatile, as indicated by their huge percentage to double and percentage that crapped out.  

Best stocks for put buyers

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