The Stock Market, as represented by the S&P 500, showed continued strength on Tuesday despite a lower close in the NASDAQ 100. Weakness on earnings and subscriptions caused Netflix (NFLX) to fall more than fourteen dollars to $94.34. Despite that, the broader S&P, as represented by the E-mini S&P 500 Futures, closed seven points higher to 2093.75 and is rapidly approaching the psychological 2100 level.
For Options Traders, when markets are trading at extremes, trading opportunities become more interesting. Since the E-mini S&P has risen substantially in the last two months, it is a good opportunity to review options pricing. While overall Implied Volatility and Options Prices in general have decreased substantially since the February lows, the structure of the options pricing has remained the same despite that fact that the market has rallied from 1800 to 2100. The fact is that out-of-the money Puts are always priced much higher than out-of-the money Calls in the S&P 500. The reason is that individuals and portfolio managers buy Puts to protect their portfolios and sell Calls to receive income against stocks they own. The theory makes sense; unfortunately, the cost of this type insurance is very expensive.
The Table below presents a significant amount of information about the E-mini S&P Options. Don’t get lost looking at it, because I’ll attempt to make a full explanation. Whenever trading options, you should be aware of the Historical Volatility of the underlying product. It gives you an idea of how the product has been moving during a particular period of time. (I’ll typically use 20 days), The Historical Volatility of 10% is listed on the left side of the table, three lines down. As a comparison it’s always nice to see the Implied Volatility of the Options, which is the expected future movement of the underlying contract. While the Historical Volatility measures past movement, Implied Volatility measures expected future movement. For any number of reasons, future movement can be significantly different than past movement, and therefore Options Trading is not a science but an art.
The Table also provides the RSI or Relative Strength Index of the underlying contract. This is a measurement that can indicate an overbought or oversold situation. I use a nine day Relative Strength Index; some people use 20 days. Typically a value greater than 70 would be an indication that a market might be overbought, while a number lower than 30 might be an indication of an oversold market. The RSI is located in the Table just below the Historical Volatility. Its current value of 78 might indicate an overbought market. It’s only a point of reference and shouldn’t be used as sole indicator of market direction.
Finally, we review the pricing of S&P Options. Reading from left to right, there is an opportunity to review a multitude of Options Pricing Factors. First and probably most importantly, is the Implied Volatility of the Option. Implied Volatility provides the mathematical value of the Option as it is backed into an Options Pricing Model. It makes comparing the value of options much easier than looking at their price. Unfortunately, it does not factor into its calculations all of the nuances of pricing. For example, the Implied Volatility of the June 2050 Put, which has a Bid of 27.75 and an Offer of 28.50, is 14.20%. Compare that to the Implied Volatility of the 1900 Put (19.40%) and you can see just how much more expensive the out-of-the money Puts are the farther you get from the current price. On the other hand, the Calls are substantially less expensive comparatively. All you have to do is examine the price of the Calls and Puts equidistant from the current trading price to see the disparity in pricing. For example, the 1900 Puts 193 points from the current trading price are trading at 788 (the midpoint of the Bid/Ask) while the 2250 Calls, which are 157 points from the current price is trading at 1.18. This pricing structure provides traders with a market bias the opportunity to build Options Trading Strategies which can meet their market bias and risk management needs. At optionsstrategynetwork.com we use this type of analysis to enhance the trading skills of individuals and corporations.
In addition to Price and Implied Volatility, the Table provides information comparing the distance of the Strike Prices to the current trading levels and the liquidity percentage of the option (derived by taking the difference between the Bid/Ask Spread and dividing it by the Asset Price. This is a way of comparing the costs of trading a particular asset and evaluating the edge given up on each trade. While trading options can seem complicated, by analyzing them in an organized fashion and understanding the essential concepts, it is possible to improve the value and leverage of your trading
OPTIONS TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. THE INFORMATION IS OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, BUT IS IN NO WAY GUARANTEED. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.