Almost every investor dreams of having insider knowledge and the legal right to profitably trade on it. Unless such investors include prison bars in their dreams it should just stay a fantasy. But traders need not have special insider information to realize when something is up. How can they tell when an options contract may be gearing up for a jump?
The Screener of Stock Options Secrets
Options premiums are partially based on volatility. If the underlying stock had a 20% price change over the previous six months, the historic volatility is 20. This directly relates to the price of the options contract. The Vega (Options Greeks) displays the relationship the option has to a one percent change in volatility.
Implied volatility is different than historic volatility since it is forward looking. Regardless of a stocks previous volatility, the option premium may be very high since a future volatile move is anticipated. Therefore, the cost of an options contract may be based on some future expected move and not on historical movements. This future expected move is represented by implied volatility.
The picture suddenly becomes clear. If a trader could find an options contract that has low historical volatility but high implied volatility, this means that someone expects a very large and unusual move in price. If a massive filming crew showed up in a small town, the residents would rightly expect something big to take place. Likewise, when high implied volatility shows up in low historic volatility options, investors should take note.
Following the link here will bring up a list of options that have such a discrepancy. Select from the drop-down menu : Stocks Low HV/IV Ratio.
Another method to find options where expectations were recently raised is to screen for a big daily increase in daily implied volatility. MarketWatch has such a screener and a link will be provided in the next section.
The Screener of Stock Options Value
Screening for high implied volatility stocks, while great for gaining insider picks, can also be expensive. If the options contract does not move wildly for some reason, the implied volatility could lessen and take much of the investors options premium with it.
Another trading strategy exists that takes advantage of exactly the opposite scenario. What if an options contract is grossly undervalued? This could happen if the stock has high statistical volatility, but the implied volatility is only a fraction of that number. If the stock continued to trade with large swings as the statistical volatility suggests, the implied volatility would jump to its proper value making the options premium soar.
This is similar to holding a basketball underwater. Sooner or later the ball will pop up to the surface.
Investors are able to view this options value screen here. This is a value play.
Stock Options Strategies and Risk
Of course, both of these strategies assume risk. Buying an options contact with high implied volatility could just be an overvalued option, or a trap. As well, some options are undervalued and cheap for good reason. A wise options trader will look further than just volatility ratios; he will perform due diligence on the underlying asset. That being said, many wealthy options traders make their living with these two simple strategies. That means they are likely worth further investigation.
Sources
"Beyond the Basics - Premium," CBOE.
"Options Education: Implied Volatility," Optionsxpress.
"Advanced Options Materials and Strategies," 18 Oct 2006, Forbes.com.
