|Written by Jared Levy, Editor, Smart Investing Daily|
|Tuesday, 07 June 2011 11:18|
|Options give an experienced trader the ability to make money in any market — no matter which way it’s headed. But did you know they can also act as a warning signal or a buy signal? Options can tell you when the market is about to go haywire, and they can also tell you when the market (or a stock) is ready for a rally.
To understand how, we need to take a step back for a second and look at exactly what an option is and what its price represents.
An option is a contract that gives an investor the right to buy or sell a stock at a certain price (called a “strike price”) by a certain date. These investments give traders a lot of flexibility that stock investors don’t have. Most investors who buy stocks can only make money if share prices climb. Options investors can make money if the stock moves in either direction by investing in the right kind of option.
Traders buy “call” options when they think the underlying stock is going to rise in price. If you think Exxon Mobil’s (XOM:NYSE) share price is going to climb from $80 to $85, you might want to buy call options. Call options increase in value when a stock’s share price climbs.
Traders buy “put” options when they think the underlying stock is going to fall in price. If you think Exxon Mobil’s share price is going to fall from $80 to $75, you might want to buy put options. Put options increase in value when a stock’s share price falls.
This last bit is how options traders make money when the market is falling.
Now that we have a basic understanding of what options are, let’s talk about how options are priced.
The Five Components That Influence an Option’s Price
Stock Price — Obviously the price of the underlying asset (stock, index, ETF, etc.) will have an effect on the price of an option.
Time Till Expiration — All options have an expiration date. The longer an option has until its expiration, the more expensive it is. You’re basically paying for more time for the underlying stock to move. The amount of time until an option expires will have a direct effect on the price.
Dividends — Believe it or not, dividends also influence option value. Dividends lower the price of calls and raise the price of puts. (When you buy an option, all the dividend math is already figured in.)
Interest — Interest rates have a fairly minor effect on most options, but they do influence option prices. Higher interest rates will increase call values and lower put values.
Volatility — If there is a high demand for an option or if a stock is extremely erratic, “implied” volatility will be higher and the option more expensive and vice versa. Here’s what that means:
When the Natural Order Is Disturbed
The fact is that most of the investment community and media know little or nothing about options. They say the Volatility Index (VIX) is telling us whether the market is overbought or oversold or if investors are scared or confident. The truth is that the VIX alone can’t even come close to predicting these things without considering other factors.
There is an innate balance and relationship between a stock and its options as well as the puts and calls themselves.
What I am about to show you is what we professionals use to spot impending danger or safe opportunities. When there is a severe disparity between different options volatility, professional traders can use it to their advantage.
One of the simplest uses is to gauge real market sentiment.
(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)
Without turning this into a math lesson or boring you all to death, I’ll keep this simple and straight forward.
Look at the chart below. This is an options chain, or a list of all the different options you can buy on a specific stock or ETF. This options chain is for the S&P 500 Index.
You will see two options highlighted. One is a put (highlighted in red) and the other is a call (highlighted in green), both of which have strike prices exactly $25 away from the current price of the stock. Logically, their prices should be the same, but…
Notice how much cheaper the call option is (IN GREEN) than the put option (IN RED). Why the huge difference in price?
I’ll give you a hint…
Note the implied volatility of each (it’s the percentage number); the put is 18.32% and the call is 14.62%. This difference is called “skew” or “vertical skew” to be more precise.
Basically skew is the difference in volatility from option to option. We option traders find all sorts of skew patterns. We even have cute names like “volatility smile” to describe them…
It’s somewhat normal to see call volatility cheaper than put volatility. That’s exactly what we’re seeing in this options chain.
This is because most investors tend to buy stock, so they will more often sell covered calls (the most popular option strategy) or buy puts against their long stock to protect themselves.
(Selling covered calls just means that you’re selling call options and you have enough shares of the actual stock to be able to sell to the options buyer if they decide to “cash in” their options contract for stock.)
Professional option traders monitor the volatility skew and look for trends or abnormalities.
I saw something very interesting happening in SPDR S&P 500 ETF (SPY:NYSE) over the past couple of days, which flies in the face of what you may think about market direction.
Not What You Would Think
OK, so if everyone thought the market was going to hell in a handbasket, you would expect everyone to be selling calls and buying puts. We’ve said this is how investors protect their stock investments. This action should be sending call prices lower and put prices through the roof. But that is NOT what is happening in the SPY!
Take a look at the chart below that tracks June options for the SPY. What you will see is the black line (Puts) has been going DOWN over the past couple days and the green line (Calls) are going UP! This tells me that investors think the S&P 500 is going to go up… at least until June option expiration (17th).
Courtesy of OptionsHouse.com
This is a very different view from what we’ve been hearing from the mainstream financial media (many are talking about a meltdown). But sometimes you have to look at the market through a different lens to get the clearer picture.
Here’s another tip: I always try to back up a market opinion with several indicators to make sure that I am on the right track. Even though it looks like the market is melting down, look for some support around the 1,275 level (in the SPX) from what I see in the options there.
Also, the 1,250 looks to be the absolute bottom that option traders may be looking at until June expiration day. That’s where the S&P 500 bottomed out in mid-March. It might not be the best news, but at least you have an idea of what the “smart money” is thinking. This level is the bottom that we saw in March.
Editor’s Note: Jared is the editor of WaveStrength Options Weekly. His method of options trading gives readers low-risk, high-success opportunities. Whether you’re a seasoned options trader, or you’re new to the game, Jared’s straightforward and clear analysis will give you the confidence to step into each options trade well-armed and ready to profit.
These are scary times. Nuclear disasters, fighting in the Mid-East, a constant threat of collapse in Europe and, let’s not forget, America’s own economic struggle. 2011 will go down as one of the most violent and volatile years on record.
But in every crisis there is an opportunity. As we’ve shown over the past 20 years, there are winners and there are losers.
Later this year, I will call the Taipan team together for our annual summit in Las Vegas. Our mission this year is simple… survival. We will bring together 11 of the industry’s brightest, most well-connected investors with a single purpose in mind — to show you how to use the coming crisis to your advantage.
To get things started, on June 20 we will host the first of our survival-themed webinars. This one focuses on using Washington’s antics to your advantage. To join this one-of-a-kind event, follow this link.
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