On July 14, I published the Framework Investing Option Strategy Playbook. A reader, who has followed me since my Morningstar days, Carey C., sent in a question about the IOI Playbook. Carey’s question– regarding the difference between the strategy map I published in the playbook and a similar grid Morningstar published–gets to the heart of how to frame the question of implied volatility in the intelligent option investor framework.
Implied volatility is one of the main drivers of option prices and predicting it is a lot of what some option traders spend their time trying to do. As you’ll see from our exchange, the intelligent option investor approach is very different–implied volatility is only important to the extent that it says something about the predicted range of future prices of a stock.
Here’s the conversation.
Question from Carey C.
Hi Erik,
I have been looking at the Options Playbook summary you sent out, and thinking about its meaning. I’m looking forward to buying your book, because I am struggling to reconcile the Morningstar 2-axis strategy map [n.b. which had volatility on one axis and stock valuation on the other] vs. this one, and better understand how your thinking has evolved in this area. Unfortunately Amazon says it won’t release for another month or I’d ask my wife to get it for my birthday.
What I am struggling with is how volatility fell out of the matrix. I had the original matrix blown up and it’s on my office wall, and it has driven many of my trades. It made sense, that when volatility was cheap or expensive it influenced your trades relative to current price and estimated valuation. And it has worked for me.
But now it’s out, replaced by the best- and worst-case valuation estimates.
I took your options training via Morningstar. I always considered myself a value investor, the notion of value-driven options investing has appealed to me. And, I wanted you to know that I have had pretty good success with it; my favorite trade has been the diagonal trade (you guys called it a “split-strike combo”), selling a put to partly finance a LEAP. I have several of those open now, with the LEAP portion expiring in January.
Thanks much,
Carey C.
Erik’s Answer
Hi Carey,
Thanks for the mail. Great to hear from you, as always, and I appreciate your thoughtful question about the IOI Playbook.
While I was at Morningstar, I started realizing that their conception of the Volatility vs. Stock Price grid had some problems, but it was already published by then and the decision was made to let sleeping dogs lie.
The main problem with the old Morningstar conception is that it perpetuates what I consider an unhelpful idea that volatility and valuation lie in two different realms: volatility in the realm of options; valuation in the realm of stocks.
One of the main points of the first part of The Framework Investing is that the option market in fact functions as a crowd-sourced stock prediction machine.
Option market participants transact in options. Looking at the prices at which options are traded, one can imply the degree to which people think the stock price will vary in the future (?implied volatility?). The degree to which people believe future stock prices will vary is, in a very real sense, a prediction of future stock prices.
So, in short?
Volatility = Valuation
and
Valuation = Volatility
By separating those two elements, you lose something essential in the process of investing.
Here?s an example? The following option is trading at an implied volatility of 30%. Is this volatility high? Or low?
The width of the cone represents the 30% volatility, but just by looking at that number or by looking at the picture of the cone, there is no way to know if the volatility is too high or too low without having a sense for the value of the stock itself.
In the following diagrams, I?ll keep that volatility exactly the same, but show situations in which the volatility is correct, too low, and too high. In each of the diagrams, my best-case valuation estimate will be shown as a triangle and my worst-case valuation estimate as a square.
Here, 30% volatility is appropriate to the valuation:
My valuation range suggests the same thing that the option market is pricing in, so in fact, in this case, 30% is the correct implied volatility for this stock.
Here?s the case where 30% is too high:
My valuation range is from $45-$65 whereas the market thinks the stock?s value is so uncertain it might fluctuate between around $30 and $90. Obviously, then, in this case, the 30% implied volatility is too high.
Last, here?s a case where implied volatility is trading too cheap.
My valuation range is well outside of the BSM cone and this means that the 30% implied volatility doesn?t capture the full valuation uncertainty of this company.
Now, there is one more element to this. That is the issue of upside and downside exposure. Options are wonderfully flexible instruments that allow an investor to tailor just the exposure he or she wants. Option investors can split upside exposure from downside exposure and decide which they want to buy or sell.
For example, in the following case, if we think of volatility as being applied separately to both the upside and the downside, we see something very interesting?
The triangle showing my best-case scenario is outside of the BSM cone. This implies that the volatility on the upside is too low.
However, the square showing my worst-case scenario is inside the BSM cone. This implies that the volatility on the downside is too high.
So, in this case, the implied volatility is both too high and too low, depending on whether you are concentrating on the downside or on the upside.
In this case, it is best to use your favorite strategy, what is properly called a ?Split Strike Combo? but what I?m calling now a ?Long Diagonal?. (I bring this difference in nomenclature up in the book as well. Since Bernie Madoff?s massive fraud, the term ?split-strike? doesn?t sound nearly as attractive as ?Diagonal.? In the option trader?s world, a diagonal is created by simultaneously buying and selling options of the same type?buy a call, sell a call, for instance. In my definition a diagonal is created by simultaneously buying and selling options of different types?sell a put, buy a call, for instance.)
Here, the upside volatility is undervalued and the best thing to do with something that is under
valued is to buy it. Conversely, the downside volatility is overvalued, and the best thing to do with something that is overvalued is to sell it.
And that is the thought process behind the IOI Option Strategy Playbook.
