A Review of the Implied Trading Range

The price of an option reflects the markets best guess about future volatility. How much the underlying stock is expected to vary from its current price! It’s a fact lost on most traders, who buy calls if they are bullish or puts if they are bearish.

But being right about whether the underlying stock will rise or fall does not always result in a profitable trade. If option premiums are expensive, the cost of playing the game may outweigh the benefits of being right about the underlying stocks direction.

Unfortunately, most traders have only a rudimentary understanding of risk and cannot translate a subjective view about risk into an assessment about whether options are overpriced or underpriced at a point in time.

For example, the at-the-money options on Goldcorp are trading at an implied volatility of 39%. Is that good or bad? Without a point of reference it is impossible to know.

The options` premium effectively handicaps the underlying market much like the spread handicaps the wager in a football game. If you were making a bet on the outcome of a football game and team “A” with a ten and two won loss record was playing team “B” with a two and ten mark I would expect team “A” to win the game based on their past records.

But if we were to make a bet on the outcome of the game and the handicap was 60 points, that would likely change our view of the outcome. While team “A” might win the game, it is highly unlikely that any professional football team would beat another by more than 60 points.

When we make investment decisions, we follow much of the same process. We make a decision to buy or sell based on technical chart patterns or fundamental analysis. If one were buying the underlying shares, there is no time line to worry about. In that sense, using some historical metric to make the decision is valid. But once the trader uses options to engage in a strategy, an assessment of the handicap is critical.

And there lies the problem! While we intuitively know that a 60 point handicap in a football game is excessive, we do not have the same intuitive feeling about implied volatility.

To deal with this, we need to translate implied volatility into an implied trading range that becomes our elusive point of reference. For example, Goldcorp (TMX: G) closed Friday at $25.05 while both the three month Goldcorp $25 strike calls and puts were trading at $1.95.

A Goldcorp January 25 straddle would cost $3.90 per share. Because the straddle will profit whether Goldcorp moves up or down, it is not dependent on direction. Its success or failure rests with the size of the move either up or down.

That is what I refer to as an implied trading range for Goldcorp calculated by adding and subtracting the total cost of the two options from the strike price of the underlying stock. The top end of the range being $28.90 ($25 + $3.90 = $28.90) the bottom end $21.10 ($25 less $3.90 = $21.10).

If you think Goldcorp will breach either end of that trading range over the next three months, then you are saying the options are undervalued. As such, option buying strategies would be the best way to engage in a directional trade on Goldcorp: buying calls if bullish or puts if bearish.

If you think Goldcorp is unlikely to move beyond this range, then you believe the options are overstating future volatility – i.e. overvalued – making option writing strategies more attractive. Covered calls or uncovered puts if one were bullish, or uncovered calls or bear call or put spreads if one were bearish.

Understanding how the option market prices risk – i.e. volatility defined by an implied trading range – is a key to determining the appropriate strategy to use to profit from the underlying stocks expected move.