For some of you reading this, you may never trade a single option contract in your life. They’re sort of complicated, don’t offer as great liquidity as other products, and are wasting assets. However, paying attention to the stock options market can still be helpful for those don’t even trade them.
For example, the prices of option straddles give us an indication of what the market is anticipating in terms of volatility. In turn, this information can be used to make better decisions in terms of position sizing.
Now, there are generally two types of volatility that traders concern themselves with. The first is historical volatility and the second being implied volatility. Historical volatility measures the amount of randomness in a stocks price for a given period. It’s usually measured by the standard deviation of a stock’s price move.
On the other hand, implied volatility is priced on how traders buy and sell stock options. For example, if traders continue to bid up the price of an option, then eventually prices for those options will be greater. If nothing else changed (the stock price didn’t move), then we can say that the implied volatility increased. On the other hand, if there is constant selling pressure in the options, the value of those stock options should decrease (if the stock price hasn’t moved), and implied volatility should be lower.
Here is a real world example. You’re thirsty for beer, and you’re at the supermarket, you can sift through the beer aisle and find a reasonably priced six-pack. There are a ton of different distributors so prices should be pretty competitive. We can say that volatility is relatively stable. On the other hand, let’s say we are at Madison Square Garden and we’re thirsty for a beer. Since there is only one vendor, and there is no re-entry if you leave the venue, then you’re at the mercy of the market-maker (aka Madison Square Garden). What normally is the cost for a six-pack of beer at the supermarket is what you’ll get for a single cup of beer at the Garden.
In this case, we can say that the high demand and lack of other choices makes volatility relatively high.
Getting back to options, implied volatility gives us the market’s best estimate on how they believe prices will move. An option straddle is a call option and put option (they are either bought together or sold together), they are of the same strike, and generally the option strikes which are closest to where the stock price is trading.
Let’s say the price of a stock is trading at $34.50, we’d look up the values of the $34.50 call and the $34.50 put and combine them.
The stock options expire in 5 days, the calls have a value of $2.20 and the puts have a value of 2.30.
Hypothetically, if you bought the straddle it would cost $4.50. That means you would need the stock price to rise/fall at least $4.50 to make money. In other words, if we take that $4.50 and divided it by the price of the stock ($34.50), we’d get 13%.
By knowing this information, you can position size accordingly. Of course, the market could get it wrong, meaning the stock price moves more or less than this. But generally, it’s a pretty solid estimate using stock options straddle.