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July 23, 2010

Where’s the Pony?

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 12:20 pm

Time to expiration, price of the underlying, implied volatility, historical volatility, puts, calls, delta, gamma, theta, vega, in the money, at the money, out of the money, intrinsic value, extrinsic value, higher commissions, egregious bid ask spreads, no options traded on a stock with a beautiful technical set up, multiple potential beasts and physiologies, LEAPS; why would one even bother with options? If I retain a shred of rationality, an open question to be sure, there must be some reason to complicate my life with these additional variables.

Ronald Reagan was fond of making a point with the story of the 8 year old boy who while visiting his grandfather’s farm fell into a pile of horse manure. When his father found him a short while later, the boy was smiling ear-to-ear and happily shoveling away the muck. When asked why, the son replied: “With this much poop, there must be a pony in here somewhere.” Option trading is gaining popularity because the pony hidden beneath the pile of muck is (drum roll please): risk control.

Traders new to options often incorrectly focus on the ability to leverage positions, but in his classic summarization of this approach Jared Woodard opines:

But leverage, as anyone who’s followed the fate of the investment banks knows, is just a means for magnifying outcomes. A leveraged risk-taker will experience more glorious wins and more disastrous losses, like a deranged person who shouts both poetry and obscenities (instead of whispering them quietly to himself, like the rest of us).

There are other logical and valid reasons for using options as one’s investment vehicle of choice to be sure, but the singular advantage of options is risk control.

Bill Burton,

Writer, Market Taker Mentoring LLC

July 6, 2010

Up And Down With Volatility: AAPL For The Teacher

Filed under: Options Education — Tags: , — Dan Passarelli @ 9:00 pm

Implied volatility is a major determinate of the magnitude of the extrinsic option premium. Considered together with time, these two factors act in concert to define the pricing of the time value (extrinsic value) of options.

Two characteristics of implied volatility are reproducibly reflected in option pricing: 1.The inverse relationship of price of the underlying security, and 2.The correlation of implied volatility with the rapidity of the price movement. The largest movements in implied volatility are therefore to be expected in a rapid downward price move of the underlying security.

Because vertical volatility skew results in an array of implied volatility values it is helpful to consider the generally accepted reference point. This benchmark value of implied volatility is the average of the implied volatility values for the at-the-money front month strikes in all but the last week of the options cycle.

It is always helpful to return to these basic concepts when significant movement occurs in order to be certain the conceptual relationships are maintained. Departure from the expected behavior is often an important clue to something nefarious afoot, as it was in the famous Sherlock Holmes investigation of the disappearance of the race horse, Silver Blaze, wherein the critical clue was that of the dog who didn’t bark.

Last Tuesday sell off in AAPL proves to be instructional when considered in light of the effects on implied volatility. AAPL closed Monday at $268.30 and the IV was 35%. AAPL gapped down Tuesday morning and by 1:00 PM was trading at $256.91 with option implied volatility of 40%. On the basis of Monday’s closing price and implied volatility values, this price represented a move of greater than 2 standard deviations.

IV responded as predicted by the usual relationship. The dog barked.

Bill Burton

Writer, Market Taker Mentoring LLC