The Da Vinci Code: The hidden messages within option chains
Traders are very opinionated and have their own view on everything. This is why we have a market of buyers and sellers. Otherwise, everyone would be on the same side of trades. This behaviour is built over time from experience and knowledge. You can do it too.
For example, you are able to tell if the stock is trending up or down by looking at the price movements in the following chart. As traders, we are trained to identify the trends and have an opinion on the stock’s direction. The next step is to pull the trigger: You can either buy the stock, short the stock (if you think it will drop) or use options. By using options, you benefit from better risk management. When you commit yourself to a long option trade, your risk is predefined. Even if the company suffers bad press overnight, the stock’s gap down at the open will not leave you with an irrecoverable losing position, because you will not lose more than the premium paid for the option.
To get started, you need to find out the expiry dates and strike prices that are available for trading. This is when an option chain comes in. If you are new to options, this is an option chain on the iShares S&P/TSX 60 Index ETF (ticker: XIU)
In an option chain, you find all the available option strike prices and expiries that are at your disposal for trading. The option chain is composed of:
- Bid price (price at which buyers are willing to buy);
- Ask price (price at which sellers are willing to sell);
- Last price (price of the last trade, if there was one, or previous day’s closing price);
- Implied volatility (the stock’s volatility that the marketplace “implies” is embedded into the option price);
- Open interest (total number of open or outstanding options); and
- Volume (traded volume of the given day). Even if there is no volume, options can be bought and sold at any given time as long as there is a bid or an ask.
What is the link between the Da Vinci Code reference and option chains? Every day, traders inject their prices and views into the options market and all this valuable information is encrypted into the option chains. Since option prices are embedded with a time value component, we can extrapolate how much a stock is expected to move before a specific date. This will not tell you the direction (up or down) of the stock, but rather by how much it will move. Once you decrypt this information, it is up to you to agree or not with the market.
Here are the steps using XIU as an example:
As of the close on Wednesday January 10, 2018, XIU was trading at $24.25.
- Lookup XIU’s option chain. We use the Feb 2018 expiry as an example.
- Find the strike price that is closest to the price of the underlying. (We are fortunate to have a strike price identical to the XIU price.)
- Take the ask prices of the Feb 16 2018 $24.25 call and put options, and add them up:
$0.30 + $0.27 = $0.57.
- For the call option, take the ask price from the next higher strike price. In this case, we use the $24.50 strike price and the $0.17 ask price.
- For the put option, take the ask price from the lower strike price. Thus, use the $24.00 strike price and use the $0.19 ask price.
- If we add up both ask prices from steps 4 and step 5, we get $0.36 ($0.17 + $0.19).
- Add the results from step 3 and 6 and divide it by 2: ($0.57 + $0.36) / 2 = $0.465.
Decryption conclusion: This means that the participants in the options market are expecting XIU to move + or – $0.465 by February 16, 2018. Remember, this can be up or down $0.465 from the current price of $24.25. Based on this information, you know by how much XIU could move.
This is how you decrypt the option chains. This method should be taken with caution because bursts of volatility in the market can affect the model. Until next time, may the best trades be with you.
National Bank Direct Brokerage (“NBDB“) is a division of and a trademark used by National Bank Financial Inc. (“NBF “) for its order-execution services. National Bank Direct Brokerage offers no advice and makes no investment recommendations. The client is solely responsible for the financial consequences of his or her investment decisions. Member of the Canadian Investor Protection Fund.
Edited on 9 April 2018