small in size, you wouldprobably decide to go ahead and sell, as it seems that the stock mightdrop even farther. The mental stop allows you this flexibility. It maysometimes cost you an extra eighth of a point versus the actual stop,but it will save you in those situations where it is fairly obvious thatthe stock is going to lift right back up. Of course, the mental stop canonly be used if you are present when the stock reaches your stopprice. If you have another job or are often away from a quotemachine, then you must use actual stops.Another type of mental stop that I have found useful is the closing stop: I won’t stop myself out unless the stock is actually closingbelow my sell stop price (or above my buy stop price). This is anorder that can be placed as an actual stop in the futures market, butnot in the stock market (“Stop, close only”). I have found that, especially with rumor stocks and other short-term situations, the stockmay trade down through what appears to be minor support, intraday, but then bounces back above it by the close of trading. If youwere using an intraday stop, you would have stopped yourself out.However, with the closing stop, you retain your position. It’s relatively easy to monitor, even if you don’t have access to a quotemachine; merely call your broker just before the close of trading, andif the stock appears that it’s going to close lower than your stop price,sell the stock. The drawback, of course, occurs when the stock notonly violates your stop level, intraday, but continues on down andcloses much lower. That is why you may want to pay attention inreal time if you are using this type of stop because you may want toliquidate your position before the close if you see a nasty situationdeveloping.In any case, placing stops can be more of an art than a science.Some traders prefer to use money management stops; that is, theywill risk only a certain amount of money on a trade and will, therefore, determine their stop price based on a dollar amount of risk.This concept is discussed in Chapter 7. Other traders prefer to usetechnical analysis to aid them in placing their stops. I think both concepts can be used together in a short-term trading methodology. Inthis system of using option volume to select stocks, we want to keepour initial losses small, approximately three-quarters of a point toone point. That is the money management part of the stop. Then, if
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we can find a point in that range that is a technical support point, wecan combine both philosophies.For example, if there have been a couple of daily bottoms at thesame price, that represents technical support. If that support isapproximately at the distance where we want our stop, we would setthe stop—actual or mental—at a point below those two daily bottoms. Figure 4.10, a chart of Bethlehem Steel (BS), illustrates thisconcept. If we bought BS at 141⁄4 (the last bar on the chart on theright), we might set our stop at 133⁄4, based on the fact that there hadbeen double bottoms at 14 during the previous week.Of course, you won’t always be able to find such a convenientthing as a double bottom, but you may often be able to identify a support area that, if breached, would be a rather negative occurrence.This would be your stop point.
Figure 4.10BETHLEHEM STEEL
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THE PREDICTIVE POWER OF OPTIONS
Figure 4.11 illustrates the concept. If you buy ADM at the lastsale (on the right of the chart), you might feel that its price representsa nice breakout. However, if it fell back below the row of daily topsthat had occurred over the preceding month at 171⁄2, the breakoutwould be negated. So you might place your stop at 17, which is wellbelow the row of intraday tops.Finally, if there is no technical support area visible, then youwould just have to rely on your money management stop. Themoney management part of the stop-selection process is the mostimportant and should be the first consideration. If, for example, youare going to place your stops at 1 point below your entry pricebecause of money management, you would not override that consideration because technical support is 21⁄2 points below your entryprice. To use a stop of 21⁄2 points below your entry price is just too
Figure 4.11ADM, 12/27/95
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far and too much risk, if your normal money management stop is 1point. The technical-analysis portion of the stop-selection processshould only be used if it falls within the guidelines of your moneymanagement stop.The preceding discussion was from the viewpoint of protecting along position in a stock. Obviously, for a short position, things wouldbe similar. A protective buy stop might be placed just above a coupleof intraday tops on the bar chart. Or if the stock has broken downbelow a congestion area, then a buy stop might be placed just abovethe intraday bottoms that defined the breakdown.Stop orders can also sometimes be used for entering a position,as can limit orders. We spent a good deal of time going over the reasons and methods for screening out option volume that was notspeculative in nature. However, we also stated that you may still endup with a stock whose increased option volume was due to something other than insiders buying options in advance of corporatenews. As one further type of screen, I often wait until I see the stocktrade above the high price it made on the day of the heavy optionvolume before I actually buy the stock. The reasoning is this: if thestock can’t even penetrate the previous day’s high, then maybe theoption volume wasn’t as good as I thought it was.If you are waiting for the stock to reach a slightly higher price(i.e., above the previous day’s high), you can use a buy stop order toget into the stock. Just place the buy stop an eighth of a point abovethe previous day’s high. If it is elected, you know the stock has continued on from the previous day’s action, and you are in a stock withmomentum. If it is not elected, you may have avoided a stock whoseoption volume was extraneous. You can, of course, leave the stop inplace for subsequent days if you continue to like the option activity.The chart of Grupo Tribasa (GTR), Figure 4.12, is a good example of this philosophy. Option volume first picked up when the stockwas trading near 8 (point A on chart). The high that day was 83⁄8,and there had been several failures, intraday, at 81⁄2 previously. Thus,even though there was good option volume, we wanted to see thestock break out to 85⁄8 before actually buying it. It could not do so fornearly a month, and then there was heavy option volume again(point B). Again, it couldn’t follow through on that volume the nextday. But, finally, it did break out three days later.
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THE PREDICTIVE POWER OF OPTIONSFigure 4.12GRUPO TRIBASA
Limit orders can also be used to enter a position. Many tradersdon’t like to “chase” stocks on breakouts, and I can agree withthat philosophy, especially if you miss the actual breakout itself.In the Grupo Tribasa example, we were able to catch the breakoutjust as it was occurring. However, you may find that sometimesyou won’t have heavy option volume until the day a breakoutoccurs. This doesn’t necessarily mean that you should avoid thestock, but you might wait for a pullback to buy it, depending onhow the news reads.Figure 4.13, the chart of U.S. Surgical (USS), illustrates this concept. In late July 1995, the stock was trading just above 23. Therehad been previous resistance at 24. On the day in question, USSbolted 11⁄2 points higher on heavy option volume and closed at thehigh of the day, 243⁄4. The situation looked attractive, but not sospectacular that the stock had to be chased and bought at the daily
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Figure 4.13U.S. SURGICAL, 7/20/95
high after its breakout. In fact, we used a limit order to buy the stockat 241⁄4, which was just over the support area. It traded down to thatlevel a couple of times over the next few days, before embarking ona move to 28.
When Option Volume Is Not aGood PredictorBefore concluding, it should be pointed out where equity option volume does not work as a predictor of a movement by the underlying.It seems to be able to work for almost all stocks, with the exceptionof gold stocks and foreign stocks. It has been my experience thatheavy option volume in gold stocks is merely a reflection of speculation in the stocks themselves and not a predictor of an upcoming
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corporate news item. Much the same is true of foreign stock ADRs,which have listed options trading. It seems that if someone actuallyhad inside information on one of those stocks, he would buy thestock in the foreign market and not risk Securities and ExchangeCommission (SEC) penalties by trading in the United States.You may also be wondering if this same concept can be appliedto index options or to futures options. After rather extensiveresearch, I have concluded that option volume is not useful in predicting the movement of either indices or futures, as it is for stocks.At first, I thought there might be some logic involved in using optionvolume to predict the movement of indices, especially sector indices.For example, if a large brokerage house was doing a positiveresearch piece on the oil stocks, then I thought the report might leakin advance and that leak would appear in the marketplace as call buying the Oil & Gas Index (symbol: $XOI). That sort of thing has justnever materialized. Either the brokerage firms are extremely secretive with their reports (unlikely), or the sector options are just too illiquid for insiders to bother with (certainly possible). Since history hasshown there to be almost no correlation between index option volume and the subsequent moves in the index, we have to concludethat index option volume is not a good predictor of index movement.As for futures options, there also seems to be no relationshipbetween an increase in option volume and a move by the underlyingfutures. This seems logical in the case of futures. There can’t be atakeover of corn or soybeans, for example. The only news items thatmaterially affect commodities are government reports of supply anddemand. These reports are closely guarded; and while many analystsattempt to predict what the government report will be, the actualreports are never leaked. The only time they were leaked was in themovie Trading Places, when Eddie Murphy and Dan Aykroyd gotthe best of the Duke Brothers. But in real life, it just doesn’t happen.So, since there are no news events that can be obtained in advanceby “insiders” in the futures markets, futures option volume cannot beused to predict the price of the underlying future in the way thatequity options are used to predict stock prices.This concludes a rather extensive section on using option volumeto predict moves in stocks. This is a valid approach to short-term
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trading, as can be seen by the many examples shown. Admittedly,the system isn’t simple and takes some work to apply, but therewards can be quite beneficial.
USING OPTION PRICES ASAN INDICATORThe actual price level of the options on a stock, index, or futures contract may sometimes also be useful in predicting the forthcomingmovements of that underlying instrument. Option premiums aresometimes useful not only in identifying corporate-news-relateditems, much as option volume is, but also in other situations. We willlook at several ways in which expensive options or cheap options areuseful for predictive purposes.Just as it was necessary to compare option volume to somethingmeaningful (its 20-day moving average of volume), it is equally necessary to have a strict measure of option prices so that we can decidewhether options are expensive or not. In order to judge the expensiveness or cheapness of options, we use implied volatility. Impliedvolatility was defined through examples in Chapter 1, but we will givea slightly more illustrative definition here, for those now familiar withthe concept.Example: As stated earlier, an option’s price is a function of:Stock PriceStrike PriceTime Remaining until ExpirationInterest RatesVolatility(We’ll omit dividends for now.) Now suppose IBM is trading at 99, andwe are attempting to determine the implied volatility of an IBM Oct 100call, trading at 7.Of the factors that compose the option’s price, four of them are knownand fixed: we know the stock price (99), the strike price (100), the timeremaining until expiration (however long it is until the third Friday in October), and the short-term interest rate. What we don’t know is volatility.
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But we do know that the Oct 100 call is trading at 7. So, what volatilitywould we have to plug into a mathematical option pricing model, given thevalues of the other four factors, to make the model say that the call wasworth 7? Whatever volatility that is, is the implied volatility.
Each separate option on the same underlying security will havesomewhat different implied volatilities. Therefore, you need to average them in some manner in order to arrive at a single daily numberfor implied volatility for the stock, index, or futures contract in question. I prefer to weight the individual implied volatilities by both theirtrading volume and the distance between the current strike priceand the option’s striking price. More heavily traded options get themost weight, and options that are either at-the-money or close to itget the most weight.Finally, once the daily implied volatility is determined, it mayoscillate rather crazily from day to day; so I prefer to use a movingaverage of implied volatilities in order to smooth things out. A 10- or20-day moving average seems to work best. If you use too “long” amoving average, then you may be including too much extraneous,“old” data in your moving average of implied volatility. We want tobe able to spot sudden changes in implied volatility, but we wantthose changes to be meaningful. It is rather common for impliedvolatility to change by quite a bit over 50 days, but not so commonfor it to change significantly over 10 or 20 days’ time.
Expensive Stock Options May PredictCorporate NewsJust as heavy option volume can be a predictor of corporate newsitems, so can expensive options, but only in certain specific situations. In fact, you may often find that option volume and impliedvolatility are increasing together in rumored takeover situations orprior to other significant corporate news releases. This phenomenonis caused once again by traders who have inside information attempting to take positions with the most leverage. When both volume andvolatility are increasing, it is usually most beneficial to apply theanalyses of option volume that were discussed earlier in this chapter.
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However, at times, you may find the implied volatility increasingwithout a concomitant increase in option volume. In many cases, thiscan be the first warning sign that someone is attempting to trade withinside information. This situation of increased volatility withoutoption volume usually occurs in illiquid options.Consider this scenario in order to see why options might get expensivebefore they get active: aggressive traders want to buy options because theyfeel they have information that will make the stock move significantly. However, the options are illiquid, so the market makers only sell the traders afew options before raising the offering price. The traders then step up andbuy a few more options at the higher price before the market makers onceagain raise their offerings. This may go on for a little while, but eventuallythe options will have gotten so expensive that the traders will stop chasingthem higher. The traders may decide to buy stock instead, or they may justbid for the options. In any case, what has happened is that the optionshave gotten quite expensive, but with very little option volume actuallyhaving traded.
We mentioned earlier in this chapter that Gerber option volumesignaled the eventual takeover in Gerber (GEB); but at that time wealso mentioned that increasing option prices were the first warningsign. You may want to compare this discussion with that previous one.Figure 4.14 shows Gerber’s stock price history, and the “wiggly”line on the bottom of the chart is the daily implied volatility of theoptions (weighted in a manner as described previously).On the bottom left of the chart, there was so little option tradingin general that there is no implied volatility line shown for many ofthose days. In fact, Gerber options were some of the most illiquidoptions listed. The stock was very dull; and as a result, traders had little interest in Gerber options. For example, GEB was locked in a narrow trading range between 27 and 29 from September 1993 untilMarch 1994, an astoundingly narrow range for seven months!However, note that in December and January, implied volatilitybegan to increase (point A). This was evidence that someone was trying to buy the options well in advance of the actual pickup in optionvolume. There wasn’t really much option volume until early March,when the stock broke out of its trading range and rallied. At that
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THE PREDICTIVE POWER OF OPTIONSFigure 4.14GERBER—IMPLIED VOLATILITY
time, you can see from Figure 4.14 that implied volatility jumped tonew highs in March as well.For the next two months—through April and May—the stock rallied, along with heavy option volume and steadily increasing impliedvolatility, culminating at point B on the graph, just before thetakeover. This “double combination” was an important harbinger ofthe takeover to come. You will notice, however, that option volumeplayers never really got “notified” until the stock had already brokenout to 32 or 33. Even then, the stock suffered a pullback to 29before eventually heading higher. However, those traders who werepaying attention to implied volatility could easily have bought in the27 to 29 range back in January or February 1994.Even casual observers of option premium levels understand thatoptions often get expensive right before a takeover or other signifi-
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cant corporate news announcement. One group of such casualobservers would be covered call writers; those covered writers maysometimes have access to lists such as “the best covered writes,”which are generally the highest returns from selling covered options.Invariably, takeover and rumor stocks appear on such a list. This isnot to say that you should write covered calls on rumor stocks; it’sjust an observation that the calls are often expensive prior to atakeover actually occurring.A friend of mine, who is a professional trader, has often said that “the onlyoption worth buying is an overpriced one.” Now, while this is a mathematical non sequitur, it has a modicum of truth in it. Obviously, in the long run,you would hurt your statistical chances of making money if you constantlybought overpriced options. However, in certain situations—and this is whatthe trader was referring to—these overpriced options foretell profitablemoves by the underlying stock.
Mathematicians will tell you that constantly overpaying foroptions is the road to ruin. If you constantly buy every rumor andevery expensive option, you will be a loser in the long run. However,expensive options can be useful in helping to pinpoint potentiallyprofitable stock movements. In fact, you might use that fact to actually buy stock rather than options.
Analyzing Implied Volatility forSpeculative TradesIt is difficult to quantify exactly how to decide if the options are“expensive,” but these are the guidelines that I use. First, the dailyimplied volatility—the weighted average of the implied volatilities foreach of the various options for today’s trading—is what I use for thecomparison. This is the most recent measure of the expensiveness ofthe options and is therefore the most useful implied volatility to compare against other statistics. This daily implied volatility can then becompared to various other implieds: the 20-day moving average ofimplied volatility and various moving averages of historical volatility.
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It seems best to compare the daily implied volatility with the various historical volatilities. If there is a significant differential betweenthem, then that is a situation that should be examined. It is lessimportant to compare the daily implied volatility with a moving average of implied volatility, because that is less likely to highlight interesting situations, especially if the implied volatility has been creepinghigher for some time. This method, by the way, is different from theanalysis that we use in Chapter 6, when we want to trade volatility.The three following examples illustrate some of the considerations that take place. The first two examples involve the Gerber options depicted in Figure 4.14.Example 1: In January 1994, with Gerber near 29 on one of the early daysof Gerber’s increased implied volatility (point A in Figure 4.14), the variousmeasures stood at these levels:Daily Implied Volatility: 51 percent10-day historical volatility: 23%20-day historical volatility: 20%50-day historical volatility: 28%100-day historical volatility: 26%20-day implied volatility average: 28%You can see that the implied volatility has literally exploded as comparedto any of the other measures of volatility. Look at the historical volatilities.They are meandering around in the mid–20 percent range, indicating thatthe stock has been rather trendless. Not much has been going on. Moreover,the recent moving average of implied volatility is low, reflecting the fact thatnot much has been happening in the options either.
Obviously, this is a situation that demands some attention—perhaps not right away (because there is always the chance of a one-dayfluke), but certainly if the implied volatility keeps registering at suchhigh levels. It did persist (Figure 4.14), allowing the purchase ofstock at low levels. (Note: buying the options at this point wouldprobably not have been profitable, for it is unlikely that you wouldhave bought options that expired in June or later. However, a stock
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buyer would have been buying near the low and could have carriedthe position profitably all the way until the takeover.)The next example is also of Gerber, but at a much later time: inMay, right before the actual takeover occurred. Once again,implied volatility had taken a sudden jump, but from much differentlevels.Example 2: By the middle of May, just a week or so before the takeover(point B in Figure 4.14), Gerber’s stock had rallied to the 35 level andoption implied volatility took another jump.Daily Implied Volatility: 84%10-day historical volatility: 67%20-day historical volatility: 55%50-day historical volatility: 57%100-day historical volatility: 44%20-day implied volatility average: 78%All of these numbers are at vastly increased levels, when compared withExample 1. First, note that the daily implied volatility is still much higherthan each of the historical volatilities.The historical volatilities themselves tell an interesting tale, too. Notehow much higher the short-term historical volatilities are as compared tothe longer-term ones. This was caused by the fact that the stock brokehigher, then fell, and then rallied (see Figure 4.14). The 100-day historicalvolatilities still contained some of the older, stodgy price movements, whilethe 10- and 20-day historical volatilities contained only the recent, volatilemovements. Nevertheless, the daily implied volatility is still higher than anyof the historical volatilities.Finally, the daily implied volatility is not much higher than the 20-dayaverage of implied volatility. Obviously, this means that implied volatilityhad been on the increase for some time.
What is important to recognize from this example is that thetakeover occurred within a week, so we should treat the precedingdata as significant. This means that a comparison of daily impliedvolatility and the 20-day average of implied volatility need not show
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a significant difference. It is more important for the various historicalvolatilities to differ from the daily volatility. When that happens, wehave a situation that is worthy of note.Example 2 showed how implied and historical volatilities lookwhen a stock has just been getting hotter and hotter until a takeoveroccurs. The next example shows a slightly different situation: a stockhad been the subject of a fairly hot-and-heavy takeover rumor, butthe rumor then died out. Suddenly, the rumor recurred, and shortlythereafter the takeover happened.Example 3: In May 1995, there was a rumor that Banksouth (BKSO) wasgoing to be taken over. At the time, implied volatility increased, as didoption volume. Moreover, the stock itself became rather volatile. However,nothing happened; and by the summer, the stock was down rather substantially from the May levels.Then, in late August 1995, the rumors returned and implied volatilitytook a sudden leap. On September 1, the volatilities were as follows:Daily Implied Volatility: 46%10-day historical volatility: 15%20-day historical volatility: 22%50-day historical volatility: 26%100-day historical volatility: 32%20-day implied volatility average: 34%The trend of historical volatilities in this example is just the opposite ofthose in the previous example. Banksouth’s actual (historical) volatility wason the wane at the time of this snapshot of volatility. It had been volatileearlier in the summer; but by September 1, it was becoming a very docilestock. The only remembrance of the earlier volatility was in the longer, 50day and 100-day historical volatilities.Note that the 20-day moving average of implied volatility is also higherthan all of the historical volatilities but is quite a bit lower than the dailyimplied volatility. Once again, the moving average of implied volatility doesnot seem to be that important.The takeover occurred the next day; and while it was a modest one—only boosting the stock by about three points—it was still a takeover.
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These examples show that implied volatility can be an importantconsideration. If it significantly exceeds the various historical volatilities, you should take a closer look at what is going on in the stock.Here are the steps that I feel should be followed in order toidentify situations such as those just described. The first two stepscan be done with a computer: (1) compare the daily implied volatility with the 20-day moving average of implied volatility; if the dailyis lower than the 20-day moving average, discard this stock; (2)compare the weighted daily implied volatility with the 10-, 20-,50-, and 100-day historical volatilities. If it is at least 20 percenthigher than three of those four historicals, the situation should beinvestigated further.Further investigation necessitates taking a look at the individualoption’s implied volatilities that make up the weighted daily impliedvolatility for the stock. It is always possible that a “strange” occurrencehas distorted the daily implied volatility, especially if you are using closing prices in your analysis. In that case, there is no speculative value tothis stock and it can be culled from your list of prospects.As an example of how individual options might distort the daily impliedvolatility, consider these data, collected in September:XYZ: 25
Daily weighted implied volatility: 33%
Option
Price
Volume
Implied Volatility (%)
Jan 20 callOct 25 callDec 25 callJan 25 callOct 271⁄2 callDec 271⁄2 call
5.750.751.001.500.130.38
1,800300100100150250
402319252623
All of the options except the Jan 20 call have implied volatilities wellbelow the weighted daily implied volatility of 33 percent. Thus, the Jan 20call is dominant, but you can see that it was probably a covered write thatcaused the volume. Speculators would not be buying a January, in-themoney call with the stock at 25 in September. Thus, you would discard XYZ
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as a stock whose increased implied volatility was a potential precursor ofcorporate developments—at least for that day.
Thus, the individual option’s implied volatility must be examined;and in doing so, the volume must be looked at as well. While theremight not be enough volume to allow the stock to make the “highvolume” screens, there should at least be a speculative pattern towhatever volume there is. Obviously, in the preceding example, thevolume did not have a speculative look to it. The following exampledepicts what we would expect to see in a typical low-volume situationwith high implied volatility.Equifax (EFX) is a small company whose options are not normally active—trading on average about 400 contracts per day. In addition, the 20-daymoving average of implied volatility is 29 percent.However, on a day in September, the daily weighted implied volatilityshot up to 44 percent. This alerts us to look at the individual options. EFXclosed at 40 on this day.Option
Price
Volume
Implied Volatility (%)
Oct 40 callNov 40 callOct 45 call
2.0002.8750.750
110120160
424450
In this case, while volume was small, it does have a potential speculative look to it. Moreover, each of the options is expensive when comparedwith the 20-day moving average of implied volatility (29 percent). So this isa stock that we would want to regard as a potential buy.
Before ending these examples, there is one other scenarioinvolving increased implied volatility that occurs with some frequency. When a stock has been the subject of a rumor for some time,its options often get quite active, thereby inflating the 20-day volumeaverage. Thus, it becomes harder and harder for the stock to appearon the high-volume list because it can’t double the now-inflated volume. In a situation such as this, your only clue to the fact that the
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stock may still be “hot” is high implied volatility. The following example details such a situation.Interdigital Communications (IDC) is a stock that had been “hot” a couple oftimes in 1995. Early in the year, it had roared from 3 to 13 on the back ofincreasing business plus rumors that it was about to win a large lawsuit fromMotorola. However, IDC eventually lost the lawsuit to Motorola, and thestock collapsed to 5. Those events caused option volume, as well as volatility, to increase a lot.However, after being calm for a couple of months, option volumepicked up again as the stock gathered momentum once more, trading up tonear 9. This once again caused option volume to increase. But nothingcame of that move, and the stock slowly began to settle below 8 as speculators exited the stock, looking for more action in other places.Then, in September 1995, Interdigital options got expensive and somewhat active. However, since the average volume was already inflated by theprevious action, the only clue for traders was the increased volatility.IDC: 73⁄4
20-day moving average of implied volatility: 60%Average daily volume: 2,444 contractsDaily Weighted Implied Volatility: