Reading Into Implied Volatility Numbers

By Scott "The Strategist" Fullman
April 16, 2002

Investors, traders, technicians, and analysts use different tools to help view current conditions and project movements into the future. This is not an easy task, especially since a mistake, misreading, or change in a signal could cost lots of money. As many of us know, through either education or experience, signals are not accurate 100% of the time. This is the reason why the use of "stop points" becomes important. Additionally, while some signals may have very high rates of accuracy, there are events that can occur which could not be picked up on a chart or other tool.

During the past two years, we have observed the usefulness of standardized option contracts, premiums, and the implied volatility readings that they produce. Analyzing the data available on the "" website has been very valuable. This information has allowed us to perform several analyses that were not available in the past. I want to take a moment and review some of the uses and show some recent events that were relevant to this data.

Some investors/traders prefer a high risk/reward ratio, while others prefer a lower ratio. By comparing the implied volatility levels of two or more stocks within an industry group, we can find stocks that are perceived to have higher risk profiles to others based on the premiums of their options contracts. The data is actually based on how much traders are willing to pay in time risk premium for option contracts on that underlying stock. By comparing the implied volatility index of one stock to another, we can determine the level of risk that is implied from the option premiums, calculated using an options pricing model and an algorithm that weights the value based on time till expiration and the difference between stock and exercise prices.

There is usually a reason why some stocks have higher implied volatility levels, or higher risk premiums, than others. In some cases the company may be having financial difficulty, such as was the case with Enron Corp. In other cases, higher option values may be the result of rumors, such as acquisitions. Implied volatility levels may also rise ahead of an earnings report, new product introduction, or even due to regulatory changes. Regardless of the reason, by comparing these values, we can determine dispersions between companies, which could allow traders and investors to take opposing positions, if they see fit.

Traders may also look to find stocks that have higher implied volatility levels as a means for writing puts and calls. The belief is that at some point the option premiums should level off between higher risk securities/options and stocks with lower risk values. For example, if a stock has a high implied volatility index versus other stocks in the group that barring an unforeseen or unusual event to everyday business activities that the premiums should decline to levels that are closer to other issues in that group. While that person might wish to profit from the higher premiums, they must realize the added risk of such positions.

Many times during the past two years, we have noted that implied volatility readings have been accurate in helping to determine trend changes. Like other tools utilized in technical analysis, by reading the implied volatility levels, there is a high degree of correlation between option premiums and the use of oscillators.

Option premiums, or the risk value within those premiums, usually decline as the price of the underlying shares rise. This is generally associated with the fact that investors and traders believe that rising stock prices mean lower levels of risk. The more people, and especially traders, that become complacent or comfortable with a stock, the lower the option premiums move. Therefore, as a stock is appreciating, there is a lower need to hedge that position by purchasing puts. As a result, when the buying pressure is nearing its end, the more people are complacent or happy with their positions. This is usually the point that people are fully invested, at least on a short-term basis. At this point, gravity takes over, and the stock is usually overbought, so a short-term correction ensues.

This was the case recently with AT&T Corp. (T). The stock price of T dropped from a high near $45 in April 2000 to a trading range between $14 and $22. Last week, the board of directors announced that they will ask shareholders to approve a 1-for-5 reverse stock split. Prior to this announcement, T shares were trading near $15. While the economic values of the shares that are held are not impacted by such a change, the perception of a higher priced stock is considered important. However, there needs to be fundamental improvements to back up such a corporate action. With no plan for improving the earnings and capital flow, this stock declined further. T shares dropped to a weekly close of $13.60. The implied volatility index jumped from 35% to 53%.

Implied volatility levels on T were near the low end of the range prior to the announcement from the board of directors. More people decided to dump their shares at that point, lifting the weekly trading activity level, while pushing the risk premium levels within the option contracts higher. As a result, implied volatility levels rose, even as the stock set new 52-week low levels. This is illustrated on the chart below.

When stocks decline, their implied volatility levels usually appreciate. Once again, this is due to the perception that the risk is increasing. Put and call writers demand higher premiums in order to offset this perceived risk. However, when combined with other forms of analysis, the formation of strategies using these options can be very advantageous.

Some of the strategies that are popular in these situations include covered call writing, naked put writing, and covered combinations. There are tools on the website that can provide help in identifying such opportunities, and the returns associated with some of those strategies. Strategy worksheets, along with the strategy scanners, located in the Strategist section of the site, have been designed to help in the data gathering and computation of those strategies. Scanners can be customized to help identify candidates that meet the requirements of the user. A report with some of the latest computer selected covered call writing suggestions are sampled below.

The website is full of important and useful tools. We suggest that you take the time and check out the tools that might be useful to you. Additionally, for more information on option strategies, the book Options: A Personal Seminar offers samples, strategy worksheets, and suggested guidelines for implementing strategies.