Our Secret Weapon for Finding Explosive Options Trades

Inside one of our proprietary options trading indicators

by Patrick Martin

    Published on Jul 19, 2018 at 4:32 PM

    Buying options is a whole different ballgame compared to buying stocks, in part because of the time value component of an option's price. Whereas a vanilla stock trader simply needs to be right on the direction of the stock's price, an options buyer needs that expected stock move to play out within a fixed period of time -- and that move needs to be substantial enough to offset the negative impact of time decay on the option's value.

    Implied volatility (IV) is a key component of time value, and it reflects the market's expectations for how much volatility the stock will realize over the life span of the option. Internally, we use a metric called the Schaeffer's Volatility Scorecard (SVS) to help us identify stocks that regularly make bigger price moves than their options IV levels would suggest. 

    SVS works by measuring a stock's realized volatility against the volatility expectations priced into that stock's at-the-money options over the past year. As such, it helps identify which stocks historically have been the best -- and worst -- for premium buyers.

    The metric 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.

    These 250 hypothetical straddle returns per stock for each year are used to calculate the SVS value, which considers three weighted 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. 

    High SVS readings (up to 100) indicate that a stock has consistently delivered bigger returns than its options IV levels have predicted, meaning it may be a strong candidate for premium-buying strategies going forward, as well. Low SVS readings (all the way down to zero) point to stocks that have consistently realized lower volatility than their options have priced in -- pointing to possible premium-selling candidates.

    It's important to remember, though, that the SVS is not necessarily predictive of future outcomes, given that it's a lagging indicator. Instead, we look at the SVS alongside coincident volatility indicators -- such as 30-day at-the-money IVs and the term structure as a whole -- and combine that analysis with our usual technical and sentiment-driven critiques to pinpoint the strongest possible stocks for option-buying opportunities.

    To learn more about identifying options trades, check out this primer on implied volatility. To get ready for earnings season, be sure to read about this options strategy.

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