It's no secret that stock volatility has jumped in recent months. This has occurred to an extent with most stocks, but some have seen much bigger jumps in their volatility and options pricing than others.
The Chicago Board of Options Exchange's volatility index, or VIX, for the
illustrates the change to volatility levels. The index began to climb past its threshold of 30 in late August, hitting an all-time high of 89.53 on Oct. 24. Year to date, the VIX has dropped back to fluctuate between a range of 39 to 57. But keep in mind that from late 2003 until July 2007, the index fluctuated between a narrow range of 10 to 20.
Whenever volatility climbs, option prices rise to reflect the higher probability that the option will pay off. For a stock holder, the effect of volatility is symmetric -- huge downward swings in the stock price are negative to the same extent that huge upswings are positive.
But for a call option holder, the impact is asymmetric. Below the strike price, there is no extra penalty for a call option expiring far below the stock price, whereas the potential upside gain of a call option on a volatile stock is much higher than on a stock with low volatility.
As the prices of options rise, open positions on call options with good-till-cancel limits win. The rise in volatility last fall was a boon to followers of my deep-in-the-money call options trading strategy, which has a solid win record of 95-1. Subscribers to my Nails on the Numbers newsletter benefited from 21 wins in the months of September and October alone.
The rising volatility during those months helped me turn positions in my April 22 pick
and July 9 pick
into lucrative wins.
Rising volatility also contributed to my overnight or same-day wins on
, to name a few.
A stock's implied volatility helps determine the premium on its options. Keeping tabs on the implied volatility of a particular option can be fairly simple using calculators available on the Web. Today, I'll use an implied-volatility calculator posted at:
Let's compare two stocks known to have contrasting betas.
has a relatively high beta of 2.1 -- double the market beta of 1.0. For the January 2010 close-to-the-money call option of $22.50, the midpoint of the bid-ask spread is $7.20. By following the needed inputs, the calculator indicates Foster Wheeler's stock has a whopping implied volatility of 84.3%.
Contrast that with government defense contractor
, which has a beta of 0.5 -- half the market beta. When calculated, SAIC's implied volatility is a very low 31.7%.
Now, let's look at the pricing on each stock's options. Because I do not recommend options so close to the money, I'll step down to call options that are about 23% to 25% below current stock prices.
For FWLT, that would be the January 2010 $17.50 strike, priced at its midpoint at $9.55 -- more than $3 higher than I would be willing to pay. For low-volatility SAIC, the January 2010 $15.00 strike is 25% below the stock price. I would consider $6 a fair price for this option. Its most recent midpoint was $5.80 -- right on the money.
Since volatility increased last year, pricing on options has made some of my usual value plays beyond the reach of my strategy. Just as my system reaped the benefit of rising volatility last fall with many wins, buying expensively priced options now would dramatically raise the risk of holding them at high prices if and when markets begin to calm and volatility drops.
When volatility declines, so will the prices on those options. For this reason, I'm sticking to my tried-and-true strategy of buying in at sensible prices for the long term. That may mean not as many positions open for the short term, but it also means the positions that do fill will have the best possible chance of closing quickly -- by avoiding the risks that come with paying prices that are too high.
Lenny "Nails" Dykstra, a guy who's used to winning, consistently profits from his deep-in the-money options calls. You can, too, with his Nails on the Numbers. Try Lenny's service free and see how it works for you. If you decide to subscribe, just one winning call will pay for a whole year!
At the time of publication, Dykstra had no positions in stocks mentioned.
Nicknamed 'Nails' for his tough style of play, Lenny is a former Major League Baseball player for the 1986 World Champions, New York Mets and the 1993 National League Champions, Philadelphia Phillies. A three time All-Star as a ballplayer, Lenny now serves as president for several privately held businesses in Southern California. He is the founder of The Players Club; it has been his desire to give back to the sport that gave him early successes in life by teaching athletes how to invest and protect their incomes. He currently manages his own portfolio and writes an investment strategy column for TheStreet.com, and is featured regularly on CNBC and other cable news shows. Lenny was selected as OverTime Magazine's 2006-2007 "Entrepreneur of the Year."