Is That Option Cheap or Expensive?

08/01/2012 6:00 am EST


Jared Woodard explains how you can use a common but very reliable metric to measure the relative value of a given option trade.

Every option trade or investment is an instance of a more general schema, an “if, then” statement: “Because of q, I believe that p, so I will risk some money to make a profit if p is true.”

The proposition could be about anything: it could be about the value of a company, the yield of a crop, or the outcome of a football game. Every case in which you risk some capital in order to profit from a future event is composed of the two activities mentioned in that schema: the process of forming a belief, and the process of risking capital on the outcome of that belief.

Structuring a desirable trade and executing the trade in the marketplace is the second process. I have written about that second process before in the context of options: the idea is that options are an essential part of any investor’s tool kit, because they allow you to express much more complex views and to express them more precisely than can typically be done with stocks or futures alone.

Buying or shorting shares of stock lets you say “yes” or “no” about a company. Structuring a position with options lets you say things like, “Yes, but only to the following extent, and before this date, and only under the following conditions...”

A lot of the educational material published about options trading tends to focus on the execution side. You can learn pretty easily about the kinds of option spreads that traders use, various order types, and so on.

But all of that instruction about how best to express your belief that assumes that you already have a carefully defined, highly informed belief that you want to express. You might not! Where do such beliefs come from, anyway? It’s not a trivial matter to look at some asset and form an idea about which you’re confident enough to risk real money.

The first process, the process of analysis, is where you form a risk-worthy belief. This is the “because of q” part of the schema above. The two most common ways that people find reasons that justify a trade are by analyzing the fundamental economic properties of assets and by studying the past price behavior of assets.

Fundamental and technical analysis, as they’re known, are by now so familiar and so easy (relative to past decades) that they are in danger of becoming trivial. A simple moving average applied to a chart or a simple filter of price-to-earnings ratios will no longer reliably produce market-beating returns, if they ever did.

A third source of information about the perceived and likely value of assets is the options market. What we might call volatility analysis is a source of data that any investor (but especially options traders) can use to form justified and risk-worthy beliefs.

Volatility analysis is a big tent, including the study of implied and historical volatility time series, of models used for forecasting asset volatility and for pricing contracts, and of order flow as an indicator of future returns and market shifts.

Next: Volatility analysis is a distinct category


Volatility analysis is a distinct category. It does not depend on the economic data favored by value and fundamental investors, and it does not rely on the chart patterns favored by technicians. And because every options contract is priced with a view toward volatility, buying or selling options without analyzing volatility means paying for something you are not using, like buying a Tesla to take your mother grocery shopping.

Click to Enlarge

Fig. 1. 1M Major Asset Volatility Risk Premium. Source: Condor Options

Here is an example of the sort of analysis I’m talking about. In the above chart, I have plotted the volatility risk premium at a one-month horizon for several major assets: stocks, bonds, oil, gold, and the euro.

This chart allows us to see how expensive options have been over time, for each asset, as a ratio of the historical volatility of that asset. In other words, it helps us identify quickly where options are relatively cheap and where they are expensive. (We track this data on a weekly basis in the Condor Options newsletter.)

At the moment, the implied volatility in iShares Barclays 20+ Year Treasury Bond Fund (TLT) options is about 40% greater than the recent historical volatility of the ETF. That’s a clue that options on TLT may be more expensive than they should be, setting up a volatility arbitrage trade with positive expectancy.

A trader looking only at economic data or at lines on price charts would have no way of knowing about this sort of opportunity, and a trader who bought or sold TLT options on the basis of those first two types of analysis would not know about the relatively high premium in the contract they were trading.

If financial instruments like stocks and options are analogous to phrases in a language, volatility analysis is the thought process that allows you to say interesting things.

At the time of publication, Jared Woodard of held positions in TLT and Treasury bond futures and options.

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