May Option Advisor: Defining 'Cheap'

The following is a reprint of the market commentary from the May edition of the Option Advisor, published on April 22. Prices and the chart are as of the close on April 22. For more information or to subscribe to the Option Advisor, click here.

We've discussed the subject of volatility many times in this space, and it has been almost exclusively from the standpoint of the CBOE Volatility Index (VIX) and, more specifically, the implications for the market of VIX behavior. I have advocated my belief that the VIX would continue to decline in 2010, a belief that I feel stood in marked contrast to a strong consensus that volatility was destined to increase substantially this year. And my view has thus far prevailed, with the VIX at its closing level on April 22 of 16.47 trading about 25% below its year-end 2009 close of 21.68.

But there is another world of options out there on thousands of individual equities, each with their own price action "footprint" and each with their own volatility characteristics. And as one who has viewed our proprietary Schaeffer's Volatility Index charts for hundreds of individual equities in recent months, I can testify that implied volatility - the volatility that is priced into the options on these equities - is at or near multi-year lows for the vast majority of stocks.

Traditional "option strategy spectrum" analysis is pretty straightforward in stating that when volatility is "low," the investor should migrate away from option strategies that sell premium (such as covered call writing and put selling) and toward option strategies that buy premium (such as naked long calls and puts, straddles and strangles). After all, you want to be a seller of premium when it's "expensive" and a buyer of premium when it's "cheap." Or do you?

I'd suggest that the option strategy decision is not nearly as black and white. The first difficulty with the "textbook" view is in defining "cheap" option premium. Does implied volatility at multi-year lows automatically qualify options as "cheap"? What if the "realized" volatility - based on the actual price movement of the stock - is considerably lower than implied volatility? In that case, wouldn't these options actually be "expensive," as the volatility expectations underlying their premiums are actually well above "real world volatility"? In fact, the Schaeffer's Volatility Index for about 82% of all optionable stocks is currently above the 20-day historical volatility of these stocks - which is a long-winded way of saying that most equity options are, in fact, "expensive" by this measure.

The second difficulty with the textbook view relates to price behavior as compared to "volatility." The traditional options pricing model is statistically based. It assumes stock price movement is random and is mean-reverting. Price trends - which are essentially the result of a directional feedback mechanism that is reinforced from day to day and week to week - are not part of the landscape for such models, even though we know they exist in the real world. Furthermore, "high" statistical volatility does not always translate into big directional movement, and some of the biggest directional movement is often accompanied by very low statistical volatility.

Take, for example, the strategy of selling put option premium, which is (not surprisingly) the cornerstone of our Put Selling portfolio. With implied volatility (and thus option premiums) steadily declining over the past year and currently at multi-year lows, what can be the rationale for a continued emphasis on this strategy? And furthermore, what can explain the fact that of the 33 Option Advisor put selling trades we've initiated and closed in 2009 and 2010, 32 have been profitable? The explanation is two-fold. First, as explained earlier, the "cheap" volatility we've been selling has actually proven to be well in excess of the actual volatility that has been realized. And second, this low realized volatility has occurred during a period in which the market has rallied steadily but dramatically, thus lowering the "success bar" for the bullishly biased put selling strategy.

This is not to suggest that the current environment is not favorable for premium buying (it is favorable with some caveats), nor to suggest that option premiums can continue to decline without reaching a point at which the put selling strategy will become unattractive (market behavior will also be an important factor here). My major purpose was to give you some food for thought that I hope will be helpful in your selection of the right option strategy, which in this game is often more important than your stock picking prowess.

"The market is ready to rebound on Monday. Based on the G-20 meeting to reduce debt will give encouragement to the market that debt will start being controlled and will force good job growth methods versus maintaing government jobs by borrowing money to keep government workers employed. This revolation will send the market into outer space. Hold on and get your stocks while they are cheap!"
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"Bernie, VIX has spiked, so are you going to give us an update?"
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