Last week, I compared two different stocks that were trading at the same price but had options contracts with wildly different prices.
When calculating an option’s price, five out of the six determinants are definitive numbers that are readily available and undisputed.
But the sixth determinant, volatility, is harder to pin down. There’s usually more than one interpretation on the table.
Volatility, as used in option pricing, is a statistical number that quantifies how erratically a stock has moved in the past, and how erratically it’s expected to move in the future.
And just like many technical indicators used for charting purposes – moving averages, the Relative Strength Index (RSI), Bollinger Bands, which can have different settings that yield different results – the volatility component can have different results, as well, based on your settings.
So, it’s no surprise that if volatility estimates vary, then option prices can vary, too.
Regardless of your inputs or how you measure volatility, one thing is certain: You can easily analyze volatility over time to determine whether it’s high or low.
That’s how you decide whether it’s in your best interest to buy options or sell them.
If you ever hear an expert on TV say that “options are cheap” or “options are expensive,” they’re referring to the level of volatility based upon its past.
One of the best-known volatility indicators is the VIX, and its value is derived by using near-term options of the S&P500. Its main function is to measure the fluctuations of the overall market.
Here’s a current monthly chart of the VIX going back to 2000.
During times of a steady and slow rise in the stock market (like the last 10 years), the VIX will trend lower. And when we have quick and violent down-moves, the VIX will spike.
As you can see from the chart, the VIX never penetrates lower than 10, but it can certainly linger there for months on end. That implies a complacent, rising market.
The quick spikes up in the VIX are accompanied by fast, heavy, short-lived down-moves in the market.
As you might have guessed, the VIX moves as an inverse to the broader market.
What does all this have to do with option prices and protection?
If You Fear A Fall, Protection is Cheap Right Now
One of the ways to protect a diversified stock portfolio is to buy put options on the S&P500. This can easily be done using the SPDR S&P 500 ETF (NYSEArca: SPY).
It’s like buying insurance for your investments.
One put option is equivalent to 100 shares of a stock or ETF, so, depending on your portfolio make-up, you can gauge how many put options you might want to buy.
And right now, with the VIX very low (near 12), put options are cheaper than they have been in the past. Think of it as the calm before the storm.
To further the metaphor, it’s almost like buying hurricane insurance well before the storm hits. It will be cheaper. If you try to buy insurance as the storm is barreling down on your house, or soon after, it’ll cost you dearly (if you can buy it at all).
So, let’s compare how much of a deal you could get now versus when options become more expensive.
One of the easiest ways to see the difference is to plug various volatility levels into an option calculator.
This put option will give you protection if the SPY falls below $275, which is about 6% lower than its current price of $291.73.
The volatility component for this specific option is 14.65% (circled).
This is slightly different than the VIX level of 12, which is calculated as an average of multiple S&P500 near-term options.
Since every option contract has its own volatility component, it’ll be different than an average-based index like the VIX.
If we raise the volatility component just five points to 19.65, which is a very feasible scenario, we now see the $275 put option costing roughly $12.15 per contract.
A roughly 34% increase in the volatility level yields a 57% increase in the price of the put option.
Now, just because volatility is low doesn’t mean a fall in the market is imminent.
If the market continues its slow ascent higher, volatility levels will remain subdued, and can even move lower. Buying put options as insurance in this case could yield losing results. It’s exactly like paying insurance on your house month after month and never experiencing a disaster.
You have the protection, but it eats a continuous hole in your wallet.
Nevertheless, if portfolio protection is what you seek, getting ahead of the game and buying put options when volatility levels are low will at least give you a pricing advantage.
One of the things I learned as a new trader long ago was to buy options on the cheap and sell when they’re expensive. The VIX is a good overall gauge to determine extremes in pricing.
If you’re an option seller like we are at Instant Income Alert, we relish the short-term down-moves in the market, as it allows us to put more money in our wallets when options are expensive.
The more you know…