Finding Option Opportunities
Options are exciting to trade for many reasons. They offer so many opportunities that the sheer volume of possibilities can be overwhelming. How can we go about finding the good ones?
To answer this, we need to think about what the sources of options profits are. What makes their prices move? The important factors are:
- Stock price movement
- Changing crowd expectations
- The passage of time
When looking for option opportunities, we can choose to emphasize any of these.
If we look closer, we will see that the last factor, passage of time, is largely a function of the second one – crowd expectations. Here’s how: when expectations for movement are high, people pay more for options. When they pay more, there is more value in the options to start with, and therefore more of it to decay away over time. The higher the expectations were in the first place, the more the option writers will have, gotten paid for selling the options, and therefore the higher their potential profits.
So it actually boils down to two things – stock price movement, on one hand, and crowd expectations (also known as Implied Volatility, or IV) on the other. When we’re looking for profitable opportunities, we can come at the problem from either of those directions. We can either look for stocks whose prices we can predict, with IV a secondary consideration; or look for stocks whose changes in volatility we can predict, with price secondary.
Of the two, changes in IV can be easier to forecast if we look for them in the right way. That is because IV has strong mean-reverting tendencies. It tends to oscillate around an average value, and return to that average quickly when it does stray away from it. This is especially true when it spikes to high values.
Screening for stocks that are at higher-than-average implied volatility levels can be a good source of option trade ideas. What we are looking for are stocks whose IV is high, not on an absolute basis, but relative to their own average IV. Once we have found some candidates in this way, we can then plan trades that take advantage of an expected drop in IV from these extra-high levels back toward average levels. IV will be the primary consideration here so we will be considering strategies where we are short time value. This will be the goal. Once we have a list of candidates that are at relatively high IV, we can then examine them to decide our forecast for the underlying price. If we are decidedly bearish or bullish, we will use bearish or bullish premium-selling strategies (naked short options, or credit spreads). If on the other hand, we believe that price will remain in a range, then we can use strategies that sell premium on both, sides puts and calls. Such strategies include short straddles, short strangles, and iron condors.
I like the approach of looking for stocks with “out-of-the-ordinary levels” of IV first, and then looking at price activity second. Both are equally valuable, and neither is sufficient on its own. But, the number of unusual IV situations is usually fairly small. They are also pretty easily located if you have access to a volatility scanning tool.
Serious trading platforms like Tradestation, Think or Swim, and Options Express, among others, provide volatility screening as part of their software. The website of the Chicago Board Options Exchange, CBOE.com, also has some screening tools.
Fig 1 is a screenshot of a scan that I ran on the Tradestation platform recently: