How to Use Volatility to Make More Money
Editor's note: Words like "delta" and "intrinsic value" might sound like gobbledygook.
But understanding how they relate to the options market can transform your portfolio forever.
In today's Masters Series – excerpted from the second half of a brand-new Retirement Trader special report – Dr. David "Doc" Eifrig explains how these concepts can help you squeeze the most profit out of the options market...
How to Use Volatility to Make More Money
Imagine our option buyer is considering another trade. Again, the strike price will be $100, and the current price is $50, so the option buyer needs the stock to move to be profitable.
In this example, this particular stock is a stable, boring water utility. The business has the same results, quarter to quarter, and the stock has drifted between $45 and $55 for years.
The stock likely won't hit $100. So the option shouldn't trade for much.
Now, let's swap in a different company. This one runs a social network with growing user counts. It also trades at $50 but in the last few months it has been as low as $10 and as high as $120. From month to month, it makes big swings up or down.
This type of stock may not sound like a good investment to you, but if you're going to make a bet that at some point it will rise to more than $100 a share, this is more likely to happen than it is with the water company.
In this case, the social network's stock has higher "historical" volatility in its share price. That makes it more likely to hit any price, and therefore, its options will trade at a higher price than they would if the stock had lower volatility.
Again though, we can get a little deeper. We talked about historical volatility in our example – the range of stock prices in the past. But traders price options based on the volatility they think a stock will have in the future, called "implied volatility."
In our example, the two businesses have fundamental differences that lead to their different volatilities. It makes sense to expect that the historical volatilities give some information about how the stock prices will move in the future.
Given that concept, we can learn a bit by thinking about options before an earnings report.
Picture a stock with a major earnings announcement coming up next week. When the earnings come out, it could cause the stock to soar or to tank depending on the results. This makes it more likely that the stock will hit almost any price, high or low.
You can see this pattern of expectations through implied volatility in certain stocks. For instance, you can tell on this chart when networking-technology giant Cisco (CSCO) will report earnings...
If you sell options at those peaks in implied volatility you'll earn more in premiums, but you'll have to ride out the earnings announcement and see how it affects the stock price.
We try to sell options when implied volatility is high to earn more, but in the end volatility isn't much more predictable than share price is. Our system works best by using the next factor, since we always know which direction it goes...
The Unstoppable March of Time
For our final section, consider two options with a strike of $100 and the stock trading at $50 a share.
If the first option expires next week, you're probably out of luck. The chances for that stock to double will be virtually zero. The option will be nearly worthless.
However, another option that expires in, say, five years is going to be worth a heck of a lot more. Expecting a stock to double isn't a great bet. But the market tends to rise over time, so the five-year option has at least some chance of paying off.
The five-year option will cost more than the one-week option. That price is known as the "time value."
Let's dive deeper.
Consider the value of a single day. Look at a scenario where the prices are closer, say, with a strike of $100 and a stock price of $99.
This option has a chance of paying out. It depends on what happens between now and expiration. With the one-week option, as each day ticks off the clock it makes a big difference. But if you have a five-year option with 1,825 days left, and the next day you've got 1,824 days left, the single day doesn't matter much at all.
The value of time is different at different stages in the option's life. This is the concept of "theta."
We can use this to our advantage by focusing on the period in which an option loses time value the quickest. Remember, as option sellers we like to sell high and watch the price decline. As time value erodes away, it works in our favor.
You can use this reasoning to figure out why we sell options that are usually two months to expiration.
Ideally, we want to have sold an option while the time value erodes away at maximum pace. An option with a long time to expiration will only lose a little value each day. And if an option is far in the money or out of the money, the last few days don't erode much time value either.
For example, if a stock is at $50 and a $40 call ($10 in the money) has five days left to expiration, the option won't have much time value left. What's the value of an extra day when the outcome is clear?
In other words, time value erodes away slowly, then speeds up, then slows down again as the option gets close to expiration. We've found around six weeks to be the period of fastest time-value erosion.
By focusing on that period, we get the most option income for each trade we make.
Can You Feel It?
A subscriber once sent us this question:
I noticed that the CCL August put prices in the "What to Do if Prices Move" table seem too much lower than the recommended put price. They seem inconsistent with each other. A $0.20 drop over the weekend does not seem right, when the TGT October price only drops $0.04 over the weekend. – A.B.
We could plug all these numbers into the Black-Scholes equation, start calculating away, double-check our answers and figure out where options prices would be. That's the stuffy Schwinger's way.
But now that we have a deeper understanding of options, we can "feel out" the answer to this question. We can act like Feynman...
The Carnival Corporation (CCL) options were several weeks out to expiration (August) while the Target (TGT) options expired two months later, in October. So it makes sense that the August options would decrease in value more quickly over a few days while an October option wouldn't move so much. The rate of time decay – or theta – increases as an option gets closer to expiration.
The only way to truly understand options is to think about these things a little bit, like we've done here. Think of examples, get on your broker's platform, and look at some option prices to see if they make sense to you.
Don't worry... you'll be able to follow Retirement Trader no matter how deeply you understand these ideas. We walk you through each and every trade. But the more comfortable you are with options, the more comfortable you'll feel placing trades and understanding what's happening with your money.
It's important to us that our readers feel that way with each trade.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig, Jr. MD, MBA
Editor's note: Over the last seven years, Doc has built one of the most impressive track records in our industry. To learn more about this incredibly lucrative strategy – and how to claim a FREE YEAR of Retirement Trader – click here.