Implied Price Moves

On rare occasion I actually get some indication that someone is reading these articles.

In this case I was recently asked a question about “implied moves,” citing the fact that I refer to that concept with some frequency in articles. For me, that implied someone actually having read at least one article. The use of the word “frequency” further implied that I did so either on multiple occasions in a single article or perhaps in many articles.

That which is implied isn’t necessarily precise.

There are lots and lots of different metrics and measures that are used in assessing stock charts and stock fundamentals. I have long maintained doubts about the validity of many of those measures, at  least the ones most frequently cited and presented. It always appears that for every expert’s interpretation of data there is another equally esteemed expert who takes an opposing position.

For someone who had spent about 20 years in academic environments and who respects the “scientific method,” I prefer common sense approaches to investing.

You can be certain that for the widely used tools and measures everyone under the sun has already applied the tools and the chances of an eye popping discovery that flies below the radar is not likely. So why bother?

The same may or may not be true of more closely held metrics or proprietary tools. Presumably the PhDs in statistics, physics and applied mathematics are being paid princely sums for their algorithms because they produce results at the margins.

If you followed the announcement of this year’s Nobel Prize in Economics you may have thought it to be ironic that the prize was shared by Eugene Fama and Robert Schiller. The ironic part is that one was recognized for his work supporting rational markets, while the other was awarded on the basis of endorsing irrational markets.

So clearly black and white can be the same.

While I only passingly glance at charts and various measures and completely ignore the traditional measures used to characterize options, better known as “The Greeks,” I do consider the option market equivalent of crowd sourcing, better known as a measure of a stock’s  “implied price move.”

While I believe that the option market usually gets it wrong, which is a good thing, because those are the people that are buying the goods that you’re selling, the crowd does provide some guidance. As in real life, it’s often good to stay away from the crowd, despite the fact that crowds can create a sense of comfort or security.

Or frenzy.

In this case the guidance provided by option market participants is an estimation of how much the option market believes a stock’s price will move during the period in question by looking at both the bull and the bear perspective as based on the most fundamental of all criterion.

What is considered is the price that someone is willing to pay to either buy a call option or a put option at a specific strike price.

I only use “implied movement” when a known event is coming, such as earnings being released. I want to get an idea of just how much the option market believes that the stock is likely to move based on the event that is going to occur.

In articles I refer to the phenomenon of “Premiums Enhanced by Earnings” or “PEE.” During such times the uncertain way in which stocks may respond to earnings news drives option premiums higher. It’s all a case of risk and reward.

But because earnings introduces additional risk I look for a measure that may suggest to me that I have an advantage over the crowd.

The calculation of the “implied move” is very simple, but is most accurate for a weekly contract, because that minimizes the impact of time on option premium.

To begin, you just need to identify the strike price that is most close to the current share price and then find the respective call and put bid premiums. By adding those together and dividing by the strike price you arrive at the “implied move.” which tells you that the option market is anticipating a move in either direction of that magnitude.

IMPLIED PRICE MOVE = (Call bid + put bid)/Strike price,  where Strike price is that closest to current share price

The implied move is expressed as a percentage.

Using Facebook as an example, the graphic below was from the day prior to the announcement of earnings and with approximately 3 1/2 days left to expiration.

Facebook was trading at $49.53 and the $49.50 November 1, 2013 call option bid was $3.10, while the corresponding put option bid was $3.05

At a point that shares were trading at $49.53 and using the $49.50 strike level, the combined call and put premium of $6.20 would result in an implied move of approximately 12.5%. That would mean that the stock market was anticipating an earnings related trading range from approximately $43 to $56.

Great, but how do we capitalize on that bit of information, which may or may not have validity, especially since it is based on prices that in part are determined by option buyers, who frequently get it wrong?

I use my personal objective, which is a 1% ROI for each new trade.

In the case of Facebook, whether buying shares acc
ompanied by the sale of calls or simply selling puts, the ROI is based upon the premiums received, plus or minus capital gains or losses from the underlying shares and of course, trading costs.

In general, there is a slight advantage in earnings related trades to the sale of puts rather than using a covered call strategy. Doing so also tends to reduce transaction costs.

In the case of Facebook, the first strike price that would yield a 1% ROI is at $42, because the bid premium at that strike is $0.44 and the amount of cash put at risk is $42.

The key question then is whether that 1% ROI could be achieved by a position that is outside of the implied range. The further outside that range the more appealing the trade becomes.

Again, in this case, with shares trading at $49.53, it would require a 15.2% decline in price to trigger the possibility of assignment. That is outside the range that the crowd believes will be the case.

In this case, I’m currently undecided as to whether to make this trade because of other factors.

There are almost always other factors.

First, the positive factor is that I prefer to sell puts on shares that have already started showing weakness in advance of earnings. That increases the put premiums available and perhaps gets some of that weakness out of its system, as the more squeamish share holders are heading for the exits in a more orderly fashion, rather than doing it as part of a rushing crowd.

The negative factor is that tomorrow is another event that may impact the overall market. That is the release of the FOMC minutes. Although I don’t expect much of a reaction in the event of a surprise or nuanced language the market could drag Facebook along with it, possibly compounding any earnings related downdraft.

So in this case I’m likely to wait until after 2 PM tomorrow to make a decision.

By that time the likelihood of any FOMC related influence will be known, but there will also need to be a recalculation of implied move as premiums will change both related to any changes in share price, as well as to decreased option value related to the loss of an additional day of premium.

In general, everything else being equal, waiting to make such a trade reduces the ROI or increases the risk associated with the trade.

Aren’t you glad you don’t read these articles?