2 Volatility Tools We Use to Find Prime Option-Buying Opportunities

How we use two proprietary volatility indicators to maximize leverage on options trades

by Patrick Martin

    Published on Sep 14, 2017 at 4:09 PM

    While earnings season is over, it won't be long before it comes around again. During this break in the action, it's a good time to review some basics about how implied volatility (IV) impacts option prices. IV plays a key role in determining the price you pay to buy an option, so it's critical to keep entry costs at a minimum in order to take full advantage of the leverage provided by options. To pinpoint stocks with attractively priced options, we've developed two proprietary volatility-based indicators: Schaeffer's Volatility Index (SVI) and Schaeffer's Volatility Scorecard (SVS).

    Finding Cheap Short-Term Options with SVI

    The Schaeffer's Volatility Index (SVI) is the average at-the-money (ATM) implied volatility of a stock's front-month options. The indicator is helpful to determine whether short-term options are currently pricing in high or low volatility expectations, relative to the past year's worth of data.

    SVI is calculated by averaging the IV of four different options -- two calls and two puts, both in the front-month series (until the week prior to expiration, when it rolls to the next available month). Two strike prices are used; the strikes immediately above and below the stock price. The resulting average IV reading is the SVI, which is then assigned an annual percentile rank (with 0% being the lowest, and 100% the highest).

    The higher the SVI percentile, the higher short-term volatility expectations are at the moment. Thus, options traders should ideally target stocks with low SVI percentile rankings, because this means near-term options are pricing in relatively low volatility expectations. Given that volatility tends to spike as known events approach, equity SVIs are usually highest prior to earnings releases.

    By avoiding options with inflated SVI readings, and honing in on those with low SVIs, premium buyers can keep their cost of entry low, minimize the negative impact of time decay, and maximize the leverage of options.

    Using SVS to Find Stocks That Defy Expectations

    Unlike the forward-looking SVI, the Schaeffer's Volatility Scorecard (SVS) is a lagging indicator that measures a stock's realized volatility against the volatility expectations priced into that stock's options over the past year. The goal is to find which stocks have been the best -- and worst -- for premium buyers.

    SVS is calculated by creating a hypothetical at-the-money straddle trade with a constant 21 days until expiration each trading day of the year, generating about 250 data points annually, with IVs derived from actual at-the-money options. The hypothetical straddle is assumed to be held until expiration, when it's closed out for intrinsic value. Based on these trades, the SVS accounts for three criteria: 40% is based on the average straddle return; 40% is based on the percentage of positive returns; and 20% is based on the percentage rank of the straddle IVs. These metrics are then combined into a score ranging from zero to 100.

    If a stock has a high SVS, the underlying equity has tended to realize greater volatility on the charts over the past 12 months than what its options have priced in. The SVS then, unlike SVI, accounts for not just IV relative to itself, but IV relative to historical volatility (HV). 

    As we work to uncover winning call and put trades for subscribers, both the SVI and SVS are critical tools we use to determine prime option-buying opportunities. To learn more about identifying options trades with appealing risk-reward setups, check out these tips, and find out how to use leverage ratios.

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