by Dave Caplan

Most stock and futures traders are familiar with approaches to option strategies that rely upon overbought or oversold levels of the underlying instrument. While it is not always easy to measure what is overbought or oversold, approaches generally use trading volume, rate of ascent (or descent) of the price of the instrument, or more exotic things such as oscillators. Option strategies can then be constructed about one’s outlook for the underlying. For example, if a stock is determined to be oversold, then one would want to employ bullish strategies. These might vary from the aggressive (outright call purchases) to the moderate (bull spreads), to the basically conservative (naked put sales – the equivalent of covered call writing). Of course, the option trader should not entirely ignore the pricing structure of the options. If the options are priced unfavorably, he may want to switch strategies or he may just buy the underlying common stock and not use options at all. A futures trader would make analogous decisions. Conversely if a stock or futures contract were determined to be overbought then strategies such as put purchases (aggressive) or bear spreads (moderate) would be in order.

The above approach generally requires one to predict the movement of the underlying instrument and then to construct an option strategy about that outlook. While this is a valid approach, it relies on being able to predict the direction of stocks and futures – not an easy task, in fact, according to some academics, it is nearly impossible, for they adhere to the outlook that price movements are virtually random. As subscribers know, we prefer to utilize market neutral strategies in our recommendations. The strategist who is doing this can also alter his strategies according to market conditions, just as the stock picker attempts to do. However, the neutral strategist – rather than trying to determine if the stock or future is overbought or oversold and therefore predict the direction of the instrument – uses the option pricing structure itself to help him in his strategy decisions. 

One way in which the pricing structure can be of use is to determine whether the options are inordinately expensive or cheap, based on historical levels. This “cheapness” or “expansiveness” is what we refer to as the implied volatility. Options on individual stocks or futures give us the measure of volatility on those instruments, while options on broad-based indices, such as OEX, S&P 500, or the Major Market Index (MMI) give us a feeling for the overall stock market. Once the strategist has determined how the options are priced he can often gear his option trading strategies to take advantage of these conditions. His reasoning is similar to that of the stock or futures picker mentioned above, but his implementation is slightly different. The stock picker feels that an overbought stock is due for a fall, the strategist feels that a stock whose options are underpriced is due to become volatile. That is, he expects the price to undergo some rather violent changes. He is not certain whether these will result in the stock going higher or lower, but he wants to make money in either case. For example, if the neutral strategist felt that options were substantially underpriced, he would look for (neutral) strategies that favor option buying. One example is a straddle purchase (buying both the put and call).

Volatility Has Implications For Others

In addition to the neutral strategist, there are other types of traders or investors that can use this information as well. One might be the stock owner who buys put options as a form of insurance. If implied volatilities are extremely low – his cost of insurance is lowered. Ironically, it may be less costly just when he needs it most if the market becomes volatile on the downside. This has been the case just before most large market downside breaks, as the cost of put insurance was quite low preceding each break. Other option buying strategies are also favored when implied volatility is low, for the obvious reason that options are cheap. However, it must be stressed again that low option prices are not a predictor of the future price direction of the underlying instrument, they only warn of increased volatility. Thus, one cannot blithely buy a large number of call options and expect to profit, for the market may drop instead.

There are other groups of option traders who prefer to sell options. Some are covered call writers. Some sell only naked puts (a strategy that is the same as covered call writing, but is more efficient in its use of capital) while others sell naked calls and puts. In any case, when options become very cheap, it is a signal to these traders to curtail their option selling activities as a price explosion may loom on the horizon.

Volatility skewing has exacerbated this effect of put sellers getting better prices for their sales and call buyers can’t seem to get any boost in price unless the market rallies substantially. As more people hear about traders or hedge funds making considerable profits from selling options they want to do the same. Thus option sellers are becoming more and more aggressive. On the other hand, option buyers are very conservative; they will not bid for options that they can buy at ever-decreasing prices from the aggressive sellers. 

History has indicated that when market psychology swings to one side or one philosophy, then it is time for the strategist to take the other side. Thus one should be concentrating on option buying strategies until this period of low volatility ends, with the proviso that one is not interested in whether the market will go up or down – merely that it will be volatile. For stock owners, this would mean buying puts as insurance. One could by index (OEX) puts as protection for his entire portfolio of stocks, or he could merely buy the puts of the individual stocks that he owns. If these puts are purchased slightly out-of-the-money, then one could still profit if the market rose abruptly, and he would be protected if it fell sharply. The strategist, on the other hand, would want to buy both puts and calls in order to be able to profit from a large market move in either direction.