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Options are Worth More Than You Think: Good Data For Stocks

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April 1, 2010
options analysis stock trading
Fredrik Broden

You hear about them on TV. Your friends ask you about them. You see the online ads. Options? No time for them. You’re a stock trader, not a geek. You have to trade the actual stock to feel human! Yeah, baby!

Okay, I’ll admit that when options traders start arguing the finer points of intraday theta, they can get, as they say in Latin, dorkus malorcus majoris. And I’m not going to try to convince you to trade options. In trading, as in pudding, the proof is in the taste, er ... profits. At the end of the day, if your account is up money, it doesn’t really matter what product you traded. So why are we killing precious ink trees with this article? Stock traders can use the data that option markets provide to help them make more informed stock trading decisions. Here’s how.

Open Interest and Volume

Open interest is an options term that refers to the number of option contracts that are still open and not yet closed. When an option is first listed on an exchange and no one has traded it, it has zero open interest. As soon as one trader buys one from another trader, the open interest goes up to 1. And if there are no other transactions in the option, and if the trader who bought the option sold it to the other trader (who is short that option, and in buying it back now has no position) the open interest drops to zero. Open interest, then, is the number of option contracts that are still “outstanding,” or held as positions in a trader’s (or your) account.

For options traders, large open interest can indicate high liquidity, and that’s a good thing. After all, an option with higher open interest usually translates to higher volume, which can make it easier to get in and out of an option at better prices. For stock traders, though, increasing open interest can indicate increasing speculative interest in a stock. I don’t think heavy trading volume in options is a reliable indicator of interest at expiration. It’s not universally applicable and is usually most evident in low-volatility environments when there isn’t much else going on in the market. But stock traders might use it as an ultra short-term indicator.

Put/call ratios simply compare all the put trading volume in a stock versus all the call trading volume in a stock. Some traders use it as a contrarian indicator because they believe that the public is generally wrong. When there is more put volume relative to call volume, the contrarian could see that as the stock being over- sold. When there is less put volume relative to call volume, it could be an indicator that the stock is overbought.

Volatility

Options traders stare at it, sweat over it, and darn near pray to it. But to stock traders, volatility typically refers to the general condition when their stock position is losing money—fast. The implied volatility of options and the extrinsic value of the options themselves go up when there is increased uncertainty (read “fear”) and go down when there is less uncertainty (read “I saw it coming a mile away”).

The textbook definition of implied volatility is that it’s the number you plug into a theoretical option pricing model to make the theoretical value of an option equal to its market value. In practice, it indicates how big a move the market thinks a stock might make. And it’s big both up and down—not just down. Think of it this way: let’s say some biotech stock is going to make an announcement next week on the FDA’s test results of the company’s wonder drug. If the results are good, the stock could rise dramatically. If the results are poor, the stock could crash. Either way, the stock could see a significant percentage change in its price. In that scenario, the options are likely to see an increase in their implied volatilities. But you already know about that announcement for that stock. So, as a stock trader, why should you care about implied volatility?

First, you probably don’t know as much as the collective market knows about a stock. And even if you’ve done your research and think that there’s nothing exceptional about an earnings announcement, news release, government report, etc., an increase in the implied volatility of the options suggests that the market thinks that the stock might move a bit more than usual. It indicates uncertainty. And if the market, which is all about uncertainty, thinks that there might be a bit more uncertainty than usual, then you should probably think about how you’re going to handle a potentially large price move. Do you have your stops in place, or are you prepared to act on mental stops? Are you prepared for a potentially large loss? Maybe you need to reduce your position.

Second, the implied volatility can be used to estimate a price range for the stock price itself.

1 standard
deviation price move
(up or down)

=

stock
price

x

implied
volatility

x

square root
(days/365)

Volatility is expressed in annual terms. But you can back that down to a shorter time frame using the square root of days / 365 (where “days” is equal to whatever number of days you’re trying to calculate the approximate move). That gives you a theoretical 1 standard deviation move. And the range you get when you add and subtract that one standard deviation move to the current stock price theoretically covers 68% of the price range of the stock. Two standard deviations covers 95% of the price range of the stock.

And while implied volatility is not a perfect indication of future stock price volatility, it can give you an indication of what might happen. Are your stops within that 1 standard deviation range? Are you prepared to be stopped out sooner than you might have expected? Do you want to adjust your stops to wider levels and accept more risk if you think the stock might move up and down in the short term before moving higher in the longer term? How you use volatility in your stock trading is up to you. But knowing what it measures and what it can indicate can be a valuable skill.

layout option chain

FIGURE 1:

Stock junkies can glean a lot from options data to make more informed decisions. In the “Layout” dropdown (1) on the Trade screen, you can pull up all of your open interest, volume, volatility, and probability data in the option chain, right on one screen (2). For illustrative purposes only.

Probability

I’ll spare you the comment about death and taxes. But in life, everything else may or may not happen. And in options, the probability of a stock reaching a certain price above or below where it is currently can be estimated using some fancy shmancy math. When you look at the probability that an option at a particular strike price might be in the money at expiration, that can tell the stock trader whether the market thinks the stock might reach your profit target price or your stop price. You might be convinced that a stock is going to rally 10% in the next month. But if the options suggest that the probability of that happening is 5%, then you might want to temper your expectations a bit. Probability is closely related to volatility. The higher the implied volatility of the options, the higher the probability that the option at a particular strike will be in the money. You don’t have to calculate any of this by hand—it’s available for free on the thinkorswim® from TD Ameritrade platform, and there’s even a probability cone built into the chart studies. At a glance, it can show you the theoretical projected price range in the future based on current volatility.

Now, did I make any mention of option trading strategies, or come down on stock trading? Nope. I sincerely hope that your stock trading is profitable. I’m rooting for you. But I will suggest that a quick scan of some basic option information might help you with position size, profit or stop loss targets, or avoiding volatile situations. Options themselves may not be part of your trading strategy, but they can help you be a more confident stock trader.

Before investing in an ETF, carefully consider the fund’s investment objectives, risks, charges, and expenses. For a prospectus containing this and other important information, please contact TD Ameritrade at 800-669-3900. Please read the prospectus carefully before investing.