SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Fundamental Volatility and Stock Prices


Every options trader must wonder whether any connection will be found between the company's fundamentals and stock prices (and in turn, option valuation as well). Because options are derived from stock price behavior, the analysis of stock movement is crucial to selecting options wisely; and that relies on volatility in the reported profit and loss over several years.

For some traders, this makes little sense. Options traders tend to be pure technical traders, concerned with implied volatility and short-term valuation of options (often ignoring how stock price behavior changes over time). This overlooks the importance of historical volatility and, equally important, of fundamental volatility as well.


Fundamental volatility is the degree of reliability in fundamental trends. Items such as revenue, gross profit, net profit and net return are of little interest to many options traders but starting there is a good suggestion. How does a trader pick one or another stock for options activity? Ask several options traders and you discover that some (if not most) have never given this much thought. This should be surprising, but the culture of the options industry tends to lack the holistic appreciation of how the company directly affects option pricing.
 

Flaws in IV versus fundamental value

Implied volatility is often viewed as the "holy grail" of options trading. This ironic because IV is an estimate based on the current levels of historical volatility. The advantage is, IV is current. The disadvantage is, it is an estimate and several attributes going into IV are assumptions, often without solid foundation. The concept of fundamental volatility many apply to macroeconomic factors of an industry as it affects the company, or it refers to a company's profit and loss trends and ratios. It may also describe credit risk or return on investment. When considering options trading, the great debate is usually between IV and historical volatility. When reported revenue and earnings are steady over a decade, fundamental volatility is low. This usually is also reflected in stock price (historical) volatility and, as a result, in options premium and its implied volatility -- usually but not always. In determining which companies to pick as candidates for options trading, this is a good starting point.


Depending on a trader's risk tolerance, it could be preferable to pick a company with high or with low fundamental volatility. The higher the fundamental volatility, the higher the risks in options trading, and the higher the profit potential. Some traders like it this way, but others would prefer low fundamental volatility and its effect on options trading risk. Profitability will be lower, but the level of predictability is lower as well, so potentially devastating losses are less likely when volatility at all levels is low.


By mathematically calculating year to year volatility (in revenue and earnings, for example) it is easy to identify levels of fundamental volatility. A company whose revenue and earnings rise steadily over 10 years is encouraging to conservative investors; this carries over to a relative degree of safety or risk in options trading as well. 

 

Direct impacts

Does fundamental volatility affect historical volatility? Everyone knows that prices rise and fall for many reasons. Some can be anticipated, and others cannot. However, low fundamental volatility tends to lead directly to low historical volatility. Strong and reliable profit and loss reports are associated directly with strong and growing stock prices and earnings per share.


The correlation is not 100% predictable because other factors also are at work – competitive trends, changes in management, mergers and acquisitions, economic changes, geopolitical influences, and much more – and these also affect stock prices. However, fundamental volatility is probably a consistent influence on stock price behavior.


A secondary direct impact is seen between historical volatility of the stock, and pricing of the option. The consistent trading stock with relatively narrow breadth of trading will develop option pricing with narrow bid/ask spread and with a tendency to reflect lower than average implied volatility. This all represents lower than average risk. When the opposite occurs – higher or erratic breadth of trading and unpredictable, sudden price reversals – options are richer due to higher implied volatility. Options traders are aware of this and often view the situation as an opportunity foe higher profits. However, it also means that risks are greater.


The measurement of fundamental volatility and its direct effect on historical volatility and option implied volatility, essentially defines levels of risk. This is seen in variations of bid/ask spread, movement in premium levels, and open interest.


A complete study of fundamental volatility should begin with the study of revenue, earnings and net return. It can be further expanded into a study of dividend yield ands the payout ratio, P/E high and low each year, and the debt to total capitalization ratio, which tests working capital more effectively and accurately than the more popular but less reliable current ratio. Of the many fundamental trends and ratios, a small number can be used to articulate fundamental volatility. Focusing on revenue and earnings, dividend trends, annual high/low of the P/E ratio, and long-term trend of the debt to total capital ratio will reveal whether a company is a conservative or high-risk candidate for options trading. This eliminates the all too common problem faced by traders: Considering themselves conservative but making trades that are high-risk.


In the options world, the question of risk tolerance and methods for picking appropriate strategies and making trades on appropriate issues, should provide the method for making sure risk tolerance affects how decisions are made. This is not practiced by all options traders, and that explains why timing problems arise and why losses occur as often as they do. As long as a conservative trader makes conservative choices, leaving the speculative traders to the willing speculator, the problems of poor selection can be reduced and eliminated.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Implied Volatility Collapse

    The key ingredient on expiration Friday is volatility collapse. At the beginning of that last trading day, there are more than 6 hours of trading yet to go. However, there are 38 hours left before expiration on Saturday. When volatility is high, OTM options are most likely to be overpriced.

    By Michael C. Thomsett,

    • 0 comments
    • 130 views
  • Trading Volatility: Why It Isn’t Always a Bad Thing

    Volatility is still widely misunderstood — and feared — by novice traders. As someone lacking in trading knowledge and experience, you often hear and believe horror stories of unstable markets. The fear is valid. After all, your shares and investments are at an elevated risk in an unpredictable environment.

    By Kim,

    • 0 comments
    • 134 views
  • Models and their limits

    Options traders tend to think mathematically. When considering selection of an underlying, risks and expected profits, the model of outcomes is a primary tool for making selections. Without a model how can anyone understand the differences between two or more options that might otherwise appear the same – similar moneyness, same strike, and same premium.

    By Michael C. Thomsett,

    • 0 comments
    • 145 views
  • When You've Only Got $1000 To Invest, What Do You Do?

    Are you new to the world of investments? Most likely; it’s not something you just fall into! BUt at the same time, investing can be done by anyone. Investing doesn’t need to be saved for retirement. It isn’t something only the uber rich are able to get into.

    By Kim,

    • 0 comments
    • 351 views
  • Use of Options Spreads to Reduce Risk

    Traders may view spreads as a means for reducing market risk. But this also means that the potential profit is just as limited as potential loss, and this is easily overlooked in the focus on risk alone. A realistic view of spreading is that it reduces risk in exchange for accepting limited maximum profit.

    By Michael C. Thomsett,

    • 0 comments
    • 439 views
  • Put Writing in 2020: The Role of Timing Luck

    The impact of luck can play a meaningful role in the short-term outcomes of monthly option trades due to the requirement to roll expiring contracts. The extreme volatility in 2020 highlightsthis fact when we look at results of SPY cash secured put trades launched on slightly different start dates.

    By Jesse,

    • 0 comments
    • 445 views
  • The problem of Option Math

    Option traders may be divided into two categories. First are those relying on instinct or casual observation. This group tends to speculate on directional movement, future volatility, value, and on potential profitability of trades. The second group is involved deeply with math of trading and depends on what is perceived as certainty or near certainty.

    By Michael C. Thomsett,

    • 0 comments
    • 618 views
  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

    • 0 comments
    • 510 views
  • Do Options Affect Stock Prices?

    It is widely acknowledged that the price of the underlying directly impacts the premium of the option. Therefore, options are termed derivatives. Their current value is directly derived from movement of the underlying price. Is the opposite also true? Does movement of the option value affect the underlying price?

    By Michael C. Thomsett,

    • 0 comments
    • 759 views
  • Portfolio Withdrawal Strategies

    This article will discuss three ways to take systematic withdrawals from your investment portfolio that would be expected to last 30 years, which is a typical time period a 65-year couple might need to plan for in retirement.

    By Jesse,

    • 0 comments
    • 583 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido