How Our Volatility Scorecard Identifies Prime Options Trades

The proprietary options volatility indicator that helps us target prime premium-buying opportunities

Editor-in-Chief
Mar 28, 2016 at 9:38 AM
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    The following is a reprint of the market commentary from the April 2016 edition of The Option Advisor, published on March 17. For more information or to subscribe to The Option Advisor, click here.

    To avoid losses, a stock trader simply needs to be right on the direction of the stock's price. However, options trading is more complex, as option contracts carry a time value component. The greater the time premium included in the option's price, the more the underlying stock needs to move in order for the option buyer to turn a profit.

    For example, with a stock priced at $50, the 45-strike call option may cost $7. This premium consists of $5 of intrinsic value, and $2 of time value. For the option trader to merely break even on expiration day, the stock needs to rise to $52. An identical option on a more volatile stock may be priced at $9 ($5 intrinsic and $4 time value) -- in which case the option trader would need the stock to rise as high as $54 in order to reach breakeven. In other words, it's not enough for the stock to simply move in the right direction -- the magnitude of the move must also exceed what the option price is predicting.

    A stock that tends to make bigger moves than its options pricing would indicate is said to have relatively "cheap" options. The cheaper the options, the easier it will be to turn a profit when buying them.

    We created our Schaeffer's Volatility Scorecard (SVS) to help us drill down on exactly these kinds of prime option-trading opportunities. The SVS is a proprietary ranking system that compares a stock's price action against the volatility expectations reflected by that particular stock's options, allowing us to determine which stocks have performed the best (and worst) for option premium buyers.

    To arrive at an SVS value for each stock, we take into account the past year's worth of option volatility data. A hypothetical call and put option (both exactly at-the-money, with 21 trading days until expiration) is created for each day of the past year (roughly 252 sessions per year). Our method assumes a straddle, using these two hypothetical options, is bought and held until expiration. The implied volatility values for these straddles are drawn from the stock's actual at-the-money call and put options with a regular monthly expiration in between two and six weeks from our hypothetical expiration date, allowing us to account for stocks that may have a significant put/call skew.

    Once the option prices are so determined, the straddle is assumed to be held for the 21 days until expiration, and then closed out at intrinsic value. This provides us with about 250 hypothetical straddle returns per stock for each year, which we use to determine the SVS value. The three primary inputs into our SVS are listed below, along with their weighting in the final value:

    1. Average straddle return (40%)
    2. Percent positive (40%)
    3. Implied volatility percent rank (20%)

    At its essence, the SVS basically looks for stocks that have had consistently mispriced options over the past year. The lowest possible SVS value of zero means that the options market has consistently overestimated the stock's propensity to make big moves, while the highest possible reading of 100 means the options market has consistently underpriced the stock's actual realized volatility. Those stocks on the lower end of the SVS scale would typically be well-suited to premium-selling option strategies, while option buyers would be better served by focusing on stocks with higher SVS readings.

    As indicated by the methodology described above, the SVS makes no attempt to be forward-looking (unless we assume that past price action and option pricing are reliable predictors of the future). In our own trading, we use the SVS as a supplement to our existing array of technical and sentiment indicators to gauge whether the past year's worth of returns have been more favorable for buying or selling option premium.

    On the premium-buying side, a high SVS score helps a stock stand out as we cull our list of potential trading ideas. And on the other side of the equation, a low SVS can serve as confirmation that a stock is ripe for a premium-selling strategy. So while the SVS alone is not a foolproof signal to buy or sell premium -- and nor is it a dealbreaker, if outweighed by our analysis of other technical and volatility indicators -- it's become very useful to us as a supplementary tool, which can serve as a "tipping point" toward pulling the trigger on a trade idea.

    Below is a list of 40 stocks -- 20 with the highest current SVS scores in our database, and 20 with the lowest current SVS scores. Names in the former table would be those that have significantly outperformed volatility expectations over the past year, while those equities in the latter table have considerably lagged the expected price swings of the options market. Again, while we wouldn't classify these as glaring "buy premium" or "sell premium" signals in and of themselves, these tables just might provide you with jumping-off points to conduct some additional research into potential trade ideas.

    top 20 SVS stocks

    lowest SVS stocks

     

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