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Why Use Options?

There are many reasons that options are used by market participants.  Day traders often look for quick access to leverage.  Hedgers may be looking to reduce their delta exposure to lock in profits (think about oil producers here – they often sell deferred calls and buy deferred puts to hedge expected future production).  Large investors may be looking for another source of liquidity, leverage, defined risk, or any other number of reasons to invest.  My approach to options is to find the best use of capital and to level the playing field between stocks.

Options level the playing field.

Each stock has a different realized volatility that describes the potential upside and downside and implies a normal distribution for the stock’s returns.  When investing in equities, the most risk-averse investors will tend to invest in low volatility names as they fear the downside move.  Risk-takers will invest in more volatile stocks as a way to expose themselves to the potential for outsized returns.

With options, the expected volatility of a stock is priced in.  If a stock is low volatility, the at-the-money call will be significantly cheaper than the at-the-money call for a high volatility stock.  In this way, when you invest in a call option, you are not necessarily betting that the stock will have a higher volatility than the rest of the equity world.  Rather, you believe that the normal distribution implied by the implied volatility is mispricing the distribution of returns in the stock.  You’re not necessarily saying that the upside is greater than any other stock, it’s just greater than the options market thinks it is.

Let’s dive into this a little more.  The Black-Scholes Model is very complex, but if you look closely at the formula, a large portion of the formula is the direct impact of volatility on the option price.  This is most true when looking at at-the-money options.  When we look into out-of-the-money options, the normal distribution assumption makes this calculation a bit funky.

The main point is that we can take 2 options with very similar characteristics – both $25 underlying, both $25 strike, no dividends, but the first stock’s IV is half that of the second stock.  This will yield a situation where the first stock’s $25 call is very close to half the price of the second.  To see this, play around with the options value calculator from the CBOE website:  http://www.cboe.com/trading-tools/ivolatility-services-free?serviceid=7

So, if one is determining which stock to buy simply for sector exposure, one may be more interested in buying the second stock mentioned above as it moves more (you can get more bang for your buck if the sector rallies as $2,500 can buy 100 shares of each stock but the second should rally twice as much).  But, if the trader believes volatility is generally priced right to get leverage, and the options on the first stock are priced such that the $25 call is 40% of the price of the second stock’s $25 call, then what?

In that case, the better trade is to buy the lower volatility stock’s $25 call as this can allow the trader to get more exposure for the same price or the same risk exposure for a lower dollar investment.  Buying 20 of the first stock’s calls gives the same exposure as 1,000 shares of that stock while for the same money, you could only buy 8 calls in the second stock and only have 400 shares of Delta exposure.  That means for the same dollars of risk premium, you can have the equivalent Delta of either 1,000 shares of the first stock or 400 shares of the second stock.  And as a result, if the magnitude of the second stock’s move is twice as much as the first stock as you expect, you only get 80% as much profit on a rally.

Options are the great equalizer.  One can find profit from investing in the options of a high-dollar, low IV stock just the same as one can find profit from investing in low-dollar, high IV stocks.  The key is entering at the right IV level – if you pay a high IV to get long options without seeing something particularly attractive about that specific name, then you’ve paid too high of a price to get into options for that name and should have been looking at options in a different name.  So, if you are buying for sector reasons, you can often get more and better exposure to a sector by buying the most attractively priced IV instead of buying the highest volatility name.

Keith Harwood

Author

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