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Desr Friend,
Last week, the market (SPY) fell 1%, the second down week in a row. Our 10K Bear portfolio gained 17.8%, after commissions. Over the past two weeks SPY has fallen by 3.4% while this bearish portfolio has gained a whopping 42.6%, proving once again that it is an excellent hedge against other investments when the market is weaker. Do you have this kind of protection in your investment accounts?
Today I would like to talk a little about an important measure in the options world – volatility, and how it affects how much you pay for an option (either put or call).
Terry
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| Option Tip of the Week |
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Volatility’s Impact on Option Prices
Volatility is the sole variable that can only be measured after the option prices are known. All the other variables have precise mathematical measurements, but volatility has an essentially emotional component that defies easy understanding. If option trading were a poker game, volatility would be the wild card.
Volatility is the most exciting measure of stock options. Quite simply, option volatility means how much you expect the stock to vary in price. The term “volatility” is a little confusing because it may refer to historical volatility (how much the company stock actually fluctuated in the past) or implied volatility (how much the market expects the stock will fluctuate in the future).
When an options trader says “IBM’s at 20%” he is referring to the implied volatility of the front-month at-the-money puts and calls. Some people use the term “projected volatility” rather than “implied volatility.” They mean the same thing.
A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number. For P & G, this number currently is 17%. That is how much the market expects the stock might vary in price, either up or down, over the course of a year.
Here are some volatility numbers for other popular companies:
IBM - 20%
Apple Computer – 31%
GE – 26%
Johnson and Johnson – 16%
Goldman Sachs – 37%
Amazon – 37%
You can see that the degree of stability of the company is reflected in its volatility number. IBM has been around forever and is a large company that is not expected to fluctuate in price very much, while Apple Computer has exciting new products that might be great successes (or flops) which cause might wide swings in the stock price as news reports or rumors are circulated.
Volatility numbers are typically much lower for Exchange Traded Funds (ETFs) than for individual stocks. Since ETFs are made up of many companies, good (or bad) news about a single company will usually not significantly affect the entire batch of companies in the index. An ETF such as OIH which is influenced by changes in the price of oil would logically carry a higher volatility number.
Here are some volatility numbers for the options of some popular ETFs:
Dow Jones Industrial (Tracking Stock – DIA) – 19%
S&P 500 (Tracking Stock – SPY) –21%
Nasdaq (Tracking Stock – QQQ) – 20%
Russell 2000 (Small Cap – IWM) – 27%
Oil Services ETF (OIH) – 32%
Since all the input variables that determine an option price in the Black-Scholes model (strike price, stock price, time to expiration, interest and dividend rates) can be measured precisely, only volatility is the wild card. It is the most important variable of all.
If implied volatility is high, the option prices are high. If expectations of fluctuation in the company stock are low, implied volatility and option prices are low.
Of course, since only historical volatility can be measured with certainty, and no one knows for sure what the stock will do in the future, implied volatility is where all the fun starts and ends in the option trading game.
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Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
You can see every trade made in 8 actual option portfolios conducted at Terry’s Tips (including the 10K Bear which does so well in weaker markets) and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
I look forward to having you on board, and to prospering with you.
Terry
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| Andy's Market Report |
The S&P 500, Dow and Nasdaq continued to struggle this past week. It was the second straight loss for the major indices.
Greece continues to put a damper on market sentiment and the reported $2 billion trading loss from JPMorgan certainly did not help the bullish cause. “Sell in May” is officially here and could linger as we move towards the summer doldrums.
Banks across the world have been suffering, Bankia in Spain, Credit Agricole in France and now JPMorgan.
JPMorgan lost $15 billion in market cap and a notch in its credit ratings on Friday. The loss by one of the most respected banks in the world. Remember, JPMorgan made it through the 2008 financial crisis without reporting a loss...an anomaly indeed.
"We know we were sloppy. We know we were stupid. We know there was bad judgment," Dimon said in an interview with NBC television to be broadcast on "Meet the Press" on Sunday.
The debacle created new concerns about big banks and provoked Dallas Federal Reserve Bank President Richard Fisher, who has called for the breakup of the top five U.S. banks, to say he is worried the biggest banks do not have adequate risk management.
The fallout extended across much of the banking sector, with shares of some of Wall Street's top names declining on Friday. Among others, Citigroup dropped 4.2%, Goldman Sachs fell 3.9% and Bank of America slipped 1.9%.
But, the greater concern remains overseas. The Eurozone is on the verge of imploding and Greece looks to be the first victim. Spain, Portugal, Ireland and possibly Italy could suffer mightily as a result from a Greek default. No one knows nor understands the true magnitude of a Greek default. And as we all know the one thing Wall Street does not like is uncertainty.
The major benchmarks have not yet pushed into a short-term oversold state, but many of the leading sectors have which typically leads to a short-term bounce. A push to 1370 and another, steeper push looks likely. Keep an eye on the 1340 to 1370 range in the S&P 500.
Crude oil futures finished lower this week, falling 2.7% to around $95.88 per barrel.
Gold futures also closed lower by about 3.75% this week, trading at $1580.39 an ounce near Friday’s close.
In notable economic news this week, claims for unemployment benefits declined to the lowest level in a month. First-time claims dropped by 1,000 to 367,000 in the period ended May 5.
Technical Mumbo Jumbo
The S&P 500 is currently stuck in a range between 1340 and 1370. The short-term risk is low as long as the major market benchmark stays above support at 1340, but a push below 1340 and the risk of a washout rises significantly. The next level of support is way down towards the 1290 area.
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| Overbought/Sold Condition Report |
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Overbought/Oversold as of May 11, 2012
• S&P 500 (SPY) – 31.2 (neutral)
• Dow Jones (DIA) – 33.4 (neutral)
• Russell 2000 (IWM) – 38.3 (neutral)
• NASDAQ 100 (QQQ) – 31.1 (neutral)
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| Testimonial of the Week |
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I can't figure out why everyone isn't using calendar spreads using your method. Sometimes it seems too good to be true. My returns the past two years have been almost unbelievable. I don't even try to tell anyone about it because they wouldn't believe me. -- Fred R
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Thank you again for being a part of the Terry's Tips newsletter. If you are interested in signing up as an Insider, visit Terry's Tips today for details.
Sincerely,
Dr. Terry Allen
Terry's Tips
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