Volatility Fundamentals

One of the reasons I think my OptionsProfits colleague Dr. Paul Price has been "filling pockets instead of filling teeth" over the last few decades is, he pays attention to the fundamentals. For a longer-term, value stock investor like him, that means price earnings ratios, forward multiples and dividend yields. However, for option traders there are more than just stock fundamentals. There are also volatility fundamentals.

Volatility fundamentals are things many traders would do themselves a huge favor to learn (something we concentrate on teaching at Option Pit). Instead of P/E ratio, one might look at historical volatility vs. implied volatility (HV/IV ratios). Options traders should pay attention to 52-week lows and highs in implied volatility instead of stock price. Options traders worry about skew and term structure instead stochastics and fibonaccis.

This is how I came up with the trade I am looking at today. Eli Lilly(LLY) 30-day implied volatility is trading at its lowest level in over two years and is trading at a significant discount to both 60-day and 90-day implied volatility. As a trader who likes fundamentals of options, this is telling me that I should really consider buying premium in the options.

Because the implied volatility is so low, I have many options in trading options. I could buy puts, calls or even a straddle. In the past week, the stock has had a range almost as great as the value of the April 35 straddle. That seems like a really decent buy. I would not fault any trader that took no direction and simply bought premium.

However, I am willing to stick a leg out there. The stock seems to be bouncing off of the lows right now and the April 35 calls are incredibly cheap in my opinion. Thus, rather than buy a straddle I am going to buy a bullish call. I do not need more than $0.25-$0.30 of a rally for this call to really start working; at that point if implied volatility is higher I could leg into a butterfly, call spread or simply exit the trade with a profit. I would be looking to make a 75%-100% gain on the call and would only look to exit if the call price fell below $0.30.

Trade: With LLY trading at $35.00, buy to open LLY April 35 calls for $0.63.

At the time of publication, Mark Sebastian held no positions in the stocks or issues mentioned.

Mark Sebastian is COO and Director of Education for Option Pit Option Mentoring. Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. Along with his role directing the path of education for Option Pit, Mark is currently the Director of Risk for a private hedge fund. He started the popular blog Option911, which is now the Option Pit blog. Sebastian has been published nationally on Yahoo! Finance, is a featured contributor for TheStreet's OptionsProfits, SFO, OptionsZone and is the managing editor for Expiring Monthly: The Option Traders Journal. Mark has a Bachelor's in Science from Villanova University.

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