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Sunday, May 9, 2021

When Share Prices Rise, So Do Options Premiums

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As the equity markets claw their way to new highs, a handful of the most successful stocks have been making huge gains – primarily in the Technology Sector.

Stocks like Apple (AAPL), Amazon (AMZN), Alphabet (NASDAQ:GOOGL) (GOOG) and Tesla (NASDAQ:TSLA) (TSLA) all trade at triple or quadruple digit share prices, representing enormous market capitalizations.

You might imagine that the market prices of options on these stocks are all fairly similar, but in reality, that’s not the case at all. The implied volatilities of these four high flyers varies significantly, and it might make a difference in what you decide to trade.

Looking at the September expiration with 28 calendar days remaining, Alphabet – parent company of Google – had implied options volatility of just 27% on Friday, just a bit higher than the S&P 500.

Options traders often speak about implied vols in terms of the cost of the straddle – the cost of the at-the-money call and put combined – along with the price of the underlying shares.

In those terms, a trader might say, “the 28 day straddle on $1,580 GOOG is trading 96 bucks.”

Amazon is a bit higher with 35% vol. In that name you might hear, “The Sep Amazon straddle is $254, but the stock is $3,280.”

Apple has been a relatively low volatility stock over the past few years, but the recent sharp rally has positively affected demand for near-term options. The Apple Sep 500 strike straddle closed on Friday near $47. That may not seem like a lot given the $254 Amazon straddle, but it’s much higher in terms of their relative share prices.

Then there’s Tesla.

It’s relatively rare to see a stock with a share price of over $2,000, a market capitalization well North of $300 billion and at-the-money options that trade at 77% implied volatility.

The Tesla straddle will cost a buyer $350 as of Friday afternoon. That’s a huge premium!

The shares of most companies don’t cost $350, and you’d own those shares forever – or until you choose to sell them. The Tesla straddle is simply a bet on how much the shares will move over the next 28 days.

Sure, if they move significantly in either direction, you could rack up big profits. Keep in mind however that a one-lot of the Tesla straddle will set you back $35,000.

This is definitely the high-limit table.

With share prices climbing quickly off of March lows, some options are gaining huge value.

Remember, just prior to their most recent earnings report, the ATM Tesla straddle was trading for about $230. That was the $1,600 strike. The next day, a seller of that straddle could buy it back for a little over a hundred bucks. That’s a profit of $13,000 for each spread sold.

By the time those options expired however, TSLA share has closed as low as $1,375 and as high as $2,050.

Depending on when a trader hedged along the way or closed the trade altogether, there was money to be made on both side of the straddle – long or short. It absolutely depends on the trades you make later.

Mathematically, there’s no difference between trading a ten-lot of a $10 straddle on a $100 stock or a one-lot of a $100 straddle on a $1,000 stock. Your risk and reward are identical.

In today’s markets however, the forces of supply and demand can cause dislocations in the prices of options relative to how much the underlying stocks could reasonably be expected to move.

Pay attention to the price of the straddle. It’s a tangible way to understand how much the options markets are expecting a stock to move over a given period of time. Sometimes it makes sense, sometime it doesn’t, and the times when it doesn’t are likely to be the best profit opportunities.

Here’s one last piece of advice that I’m paraphrasing from the narrative of a very accomplished Chicago options trader named Tony Saliba as he was quoted in the incredible book “Market Wizards” by Jack Schwager 30 years ago.

Trade a one lot!

You love a trading idea? Execute the smallest amount possible. At best, you lock in a nice, easy profit. At the absolute worst, when things go in exactly the opposite direction you were expecting, you take a manageable loss and live to fight another day.

Either way, you learn what works and what doesn’t. And why.

When options are expensive, that’s when serious money changes hands. Make sure you don’t get in over your head.

-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.

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