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Why Option Prices are Often Different:
The wild card in option prices is implied volatility (IV). When IV is high, option prices are higher than they are when IV is lower. IV is determined by the market’s assessment of how volatile the market will be at certain times. A few generalizations can be made:
1. Volatility (and option prices) are usually lower in short trading weeks. When there is a holiday and only four trading days, IV tends to be lower. This means that holiday weeks are not good ones to write calls against your stock. It is also a poor time to buy calendar spreads. Better to write the calls or buy the calendar spread in the week before a holiday week.
2. Volatility is higher in the week when employment numbers are published on Friday. This is almost always the first week of the calendar month. The market often moves more than usual on the days when those numbers are published, and option prices in general tend to be higher in those weeks. These would be good weeks to sell calls against your stock or buy calendar spreads.
3. IV rises substantially leading up to a company’s earnings announcement. This is the best of all times to write calls against stock you own. Actual volatility might be great as well, so there is some danger in buying the stock during that time.
4. Calendar spreads (our favorite) are less expensive if you buy spreads in further-out months rather than shorter terms. For example, if you were to buy an at-the-money SPY calendar spread, buying an August-July spread would cost $1.44, but a September–August spread would cost only $.90. If you were to buy the longer-out month spread and waited a month, you might be able close out the spread for a 50% gain if the price is about the same after 30 days.
Today we created a new portfolio employing further-out calendar spreads at Terry’s Tips. We used the underlying SVXY which (because of contango) can usually be counted on to move higher (it has averaged about a 45% gain every year historically, just as its inverse, VXX, has fallen by that much). We added a bullish diagonal call spread to several calendars (buying December and selling September) to create the following risk profile graph:
We will have to wait 109 days for the September short options to expire, and hopefully, we will not have to make any more trades before then. This portfolio was set up with $4000, and we have set aside almost $400 to make an adjusting trade in case the stock makes a huge move in either direction.
The neat thing about this portfolio is that there is a very large break-even range. The stock can fall about $15 before we lose on the downside, or it can go almost $30 higher before we lose on the upside. With the extra cash we have, these break-even numbers can be expanded quite easily by another $10 or so in either direction, if necessary.
It would be impossible to set up a risk profile graph with such a large break-even range if we selected shorter-term calendar spreads instead of going way out to the December-September months. Now we will just have to wait a while before we collect what looks like a 25% gain over quite a large range of possible stock prices.
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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. seth@terrystips.com
You can see every trade made in 8 - 10 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
Even better, you can become a Terry’s Tips Insider, and receive all our educational reports and materials absolutely free by opening a new account at the best options broker around - thinkorswim. If you open an account with our link, they will give you 60 days of free trading or up to $600, the same deals they give to everyone who opens an account with them. You must use this link to sign up - open thinkorswim account – and once you have funded your account with at least $3500, email Seth@TerrysTips.com and let him know that you have done it, and this is what he will do – sign you for our Premium Service package ($119.95 value plus an extra 4 months of our Premium Service, valued at another $190.80). You get $300.65 worth of services without paying us one penny.
I look forward to having you on board, and to prospering with you.
Terry
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