How to Tell If an Option Trade Is Worth Your Money

Investors' growing concerns - like what the Fed will do in the future, how China's economic situation will pan out, and where oil will end up - are driving the markets right now.

And this uncertainty can turn that winning option trade of yours into a huge disappointment - in a matter of seconds.

Look at what happened to Netflix Inc. (Nasdaq: NFLX) this year, for example.

But I have some great news for you...

You can predict just how much a stock will move in the future before you spend a penny on your next trade.

And it's easy...

Use Implied Volatility to Predict Future Stock Moves - and How They Could Cost You

Over the past few weeks, we've looked at different indicators to use to decide when to get in or get out of the market. Yesterday, we talked about the master of them all. Remember, volume can tell you where a stock is going and when it will get there.

Now that we understand what can affect a trade right now, it's time to think about the how a trade could be affected in the future and how this could help or hurt your wallet.

And given what we've been seeing in the markets over the past couple of weeks, it's important that we talk about "implied volatility" today.

But first, let's start by understanding volatility and what makes implied volatility different.

Volatility is, simply put, the fluctuation in the price movement of a security (in our case, a stock) over a period of time. Volatility helps us understand how a stock's price will change between the time we buy an option and the time that option expires. This allows us to make better decisions on whether we should buy or sell our positions and when.

Implied volatility (IV) is the measurement of how much a stock will move in the future.

Instead telling us where a stock is going to go, IV tells us the probability of how much a stock will move in the future - which affects the price you'll pay for the next option you want to buy.

Here's why...

Volume is a major determinant of IV. When there's a high demand for a stock, then the price of that stock rises. As a result, the IV for that stock rises, causing a higher premium (what you pay) for the option. Conversely, when there's a low demand for a stock, then the price of that stock drops. As a result, the IV for that stock drops, causing a lower premium for the option.

This means that a low demand for a stock causes lower implied volatility, which deems the option less risky - making it cheaper for you to buy. A high demand, however, causes higher implied volatility, which deems the option more risky - making it more expensive for you to buy.

If a stock's implied volatility changes for the worse, then you're looking at a potential loss on your trade. If it changes for the better, then you're looking at a potential profit.

Be Careful About Comparing Stocks When Using Implied Volatility

One thing I must stress in particular when it comes to implied volatility is this: Just because two stocks may show the same movements does not mean that both stocks have the same IV ranges.

Here's what I mean...

Notice that both of the stocks shown above are priced at around $67 per share, have the same strike prices, and the same expiration dates (30 days)... yet their option premiums (the price you'll pay for the option) are dramatically different. Both of these stocks are moving in about the same trading range, though they are not correlating together.

Now other indicators may give us a clue as to whether these stocks are overbought or oversold. But there's nothing here that gauges how much they are likely to rise or drop in the future.

Let's take a look at look at two stocks and see what the options tell us...

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The table above represents the Wal-Mart Stores Inc. (NYSE: WMT) March 2016 call options. As you can see, the $66.50 calls last traded at $0.96. This means that (all things being random) WMT has a higher probability of staying below $67.46 (the option strike price of $66.50 plus the premium price of $0.96) by its March expiration date.

Now let's look at Alibaba Group Holding Ltd. (NYSE: BABA)...

Just like the WMT call options, the BABA March 2016 call options above have the same strike price and the same expiration date. But... it will cost you $2.84 to buy these calls compared to the $0.96 you'd pay for the WMT calls.

This is because the expectation is that BABA will move more than WMT in the future. This means that BABA is much more volatile than WMT, which means that the BABA call options have more risk than the WMT call options... and this means that they will cost you more to buy.

Something I do is calculate near-term volatility levels based on price and then chart that volatility similar to stocks. And what I've found over my many years of doing this is that it's much easier to predict volatility than it is to predict price.

That's because volatility has a distinct pattern. It's typically at its lowest between events - like earnings - and at its highest just before major announcements - like a merger.

So let's look at WMT and BABA again. But this time, we're going to check out the volatility graphs of each...


What you're looking at above is a volatility graph of WMT. It shows that volatility was at its highest just before the earnings announcement last week, and afterwards, dropped hard. This indicates that the volatility risk is at near annual lows. And with values at just 20, the IV for WMT is low - which means the expectation is that it will move very little in the future (30 days in this case).

Now let's look at the IV for BABA...

As you can see, volatility dropped off a bit from its highs just after the earnings report was released. But current volatility levels show BABA at 40 - which is twice the rate as WMT. What this means is that the IV for BABA is much higher than that of WMT, and that we can expect BABA to move twice as much as WMT in the future.

The decision you're left with is whether or not you want to pay more for a higher-risk option that offers a greater reward or pay less for a lower-risk option that offers a lesser reward.

Although IV does not tell you the direction a stock is heading, it does tell you how much a stock will move in the future - which tells you if it's worth your money. And in this environment, this information alone could make or break your wallet.

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About the Author

Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.

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