Indicator of the Week: Are Cheap Options Really a Better Deal?

In recent months, options on higher-volatility stocks have tended to outperform

Senior Quantitative Analyst
Jun 22, 2016 at 7:00 AM
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While option prices are based off of stock prices, option trading and stock trading are quite different. A buy-and-hold long-term investor does not have to worry about volatility. Option traders, on the other hand, have expiration dates to deal with, so volatility is key. Option prices consist not only of intrinsic value, but also of time value, which determines the implied volatility of the stock. The stock move must overcome this time value for the option to make a profit, and of course, the move must occur before the expiration date. 

Option prices vary widely across stocks. Established large-cap companies typically have very cheap options, while smaller, more speculative companies generally have expensive options. An example will help to show my point. There is more certainty in the fundamental performance of McDonald's Corporation (NYSE:MCD) than that of Palo Alto Networks Inc (NYSE:PANW), so MCD will have cheaper options. I compared the prices for their front-month at-the-money (ATM) call options, which will expire on Friday, July 15. As you can see in the table below, the implied volatility on the MCD call option -- 14.4% -- is less than half the implied volatility on the PANW call option, which sits at 36%. Thus, for an ATM call option to break even on MCD, the underlying stock only needs to increase by 1.75% before expiration. For PANW, the required stock move is more than double that, at 3.89%.  

IOTW Example Stocks

Why would anyone choose a PANW call option over a MCD call option? The implied volatility reveals that PANW is expected to trade in a much wider range. In other words, there is a higher probability of a big stock move in PANW than MCD. 

That's the trade-off option players make. They can buy a low-priced option that profits handsomely on a relatively small move by the stock, or they can buy a high-priced option on a stock that needs to make a sizable move, but the potential for that sizable move is greater. In the analysis below, I take a look to see which trade-off has worked out best lately. 

Low Implieds vs. High Implieds: One way to measure the extent to which options are mispriced is to look at straddle returns on stocks. A straddle is when you purchase both a call option and a put option. It makes money when the stock moves enough in either direction to overcome both premiums. 

Specifically for this analysis, I went back to the beginning of 2015, and assumed that for each regular monthly expiration date (third Friday of the month), you purchased an at-the-money straddle that expired the next expiration date. I assumed you held the straddle until expiration and closed it at intrinsic value. I did this for each stock that had options that met some pretty strict liquidity criteria. Then I grouped the stocks into four different brackets by their implied volatility. 

The table below shows the results. Notice the average implied volatility of each of the brackets. You see the lowest implieds in bracket 1, and they get higher as you move down the table. Before comparing the brackets, note that the average return of every bracket is negative. I don't want you to get the impression that straddles are inherently a bad strategy. My method involved buying a straddle on the entire universe of stocks. Because of the bid/ask spread, this almost guarantees a negative average return during normal times.

The data shows pretty clearly that since 2015, generally speaking, it was better to buy expensive options on more speculative companies than to buy cheap options on low-volatility names. The group of stocks with the highest implied volatilities averaged a slight loss of 1.66%, with over 40% of the returns positive. At the top of the table, straddles with cheaper options showed an average loss of over 12%, and less than 35% of them were positive. I also found the percentage of straddles that would have doubled your money. The highest implied volatility names doubled 10.1% of the time compared to just 6.7% of the time for cheaper options. 

 IOTW Straddles since 2015

June Expiration: Here's a similar analysis, except it includes only the data from the most recent options expiration, on June 17. Again, the high-volatility names performed the best, averaging an impressive 32% return per trade. Nearly half of the straddles were positive. In this expiration, however, the cheapest options also performed well, averaging a positive return of 5.14% per straddle. The middle two brackets were the underperformers.  

IOTW Straddles June 2016

The tables above show that, lately, the more expensive options have been the best deals for option traders. In an effort to prevent readers from coming to the erroneous conclusion that expensive options are always the best deal, the data below is from a similar analysis, using data from the full year 2014. Unlike the more recent data, here, the stocks with low implied volatilities had the best-performing straddles, averaging a very slight loss. The expensive options, which have outperformed recently, made up the worst-performing group, averaging a loss of almost 9% per straddle. 

 IOTW Straddles in 2014

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