For some traders, this makes little sense. Options traders tend to be pure technical traders, concerned with implied volatility and short-term valuation of options (often ignoring how stock price behavior changes over time). This overlooks the importance of historical volatility and, equally important, of fundamental volatility as well.
Fundamental volatility is the degree of reliability in fundamental trends. Items such as revenue, gross profit, net profit and net return are of little interest to many options traders but starting there is a good suggestion. How does a trader pick one or another stock for options activity? Ask several options traders and you discover that some (if not most) have never given this much thought. This should be surprising, but the culture of the options industry tends to lack the holistic appreciation of how the company directly affects option pricing.
Flaws in IV versus fundamental value
Implied volatility is often viewed as the “holy grail” of options trading. This ironic because IV is an estimate based on the current levels of historical volatility. The advantage is, IV is current. The disadvantage is, it is an estimate and several attributes going into IV are assumptions, often without solid foundation. The concept of fundamental volatility many apply to macroeconomic factors of an industry as it affects the company, or it refers to a company’s profit and loss trends and ratios. It may also describe credit risk or return on investment. When considering options trading, the great debate is usually between IV and historical volatility. When reported revenue and earnings are steady over a decade, fundamental volatility is low. This usually is also reflected in stock price (historical) volatility and, as a result, in options premium and its implied volatility — usually but not always. In determining which companies to pick as candidates for options trading, this is a good starting point.
Depending on a trader’s risk tolerance, it could be preferable to pick a company with high or with low fundamental volatility. The higher the fundamental volatility, the higher the risks in options trading, and the higher the profit potential. Some traders like it this way, but others would prefer low fundamental volatility and its effect on options trading risk. Profitability will be lower, but the level of predictability is lower as well, so potentially devastating losses are less likely when volatility at all levels is low.
By mathematically calculating year to year volatility (in revenue and earnings, for example) it is easy to identify levels of fundamental volatility. A company whose revenue and earnings rise steadily over 10 years is encouraging to conservative investors; this carries over to a relative degree of safety or risk in options trading as well.
Does fundamental volatility affect historical volatility? Everyone knows that prices rise and fall for many reasons. Some can be anticipated, and others cannot. However, low fundamental volatility tends to lead directly to low historical volatility. Strong and reliable profit and loss reports are associated directly with strong and growing stock prices and earnings per share.
The correlation is not 100% predictable because other factors also are at work – competitive trends, changes in management, mergers and acquisitions, economic changes, geopolitical influences, and much more – and these also affect stock prices. However, fundamental volatility is probably a consistent influence on stock price behavior.
A secondary direct impact is seen between historical volatility of the stock, and pricing of the option. The consistent trading stock with relatively narrow breadth of trading will develop option pricing with narrow bid/ask spread and with a tendency to reflect lower than average implied volatility. This all represents lower than average risk. When the opposite occurs – higher or erratic breadth of trading and unpredictable, sudden price reversals – options are richer due to higher implied volatility. Options traders are aware of this and often view the situation as an opportunity foe higher profits. However, it also means that risks are greater.
The measurement of fundamental volatility and its direct effect on historical volatility and option implied volatility, essentially defines levels of risk. This is seen in variations of bid/ask spread, movement in premium levels, and open interest.
A complete study of fundamental volatility should begin with the study of revenue, earnings and net return. It can be further expanded into a study of dividend yield ands the payout ratio, P/E high and low each year, and the debt to total capitalization ratio, which tests working capital more effectively and accurately than the more popular but less reliable current ratio. Of the many fundamental trends and ratios, a small number can be used to articulate fundamental volatility. Focusing on revenue and earnings, dividend trends, annual high/low of the P/E ratio, and long-term trend of the debt to total capital ratio will reveal whether a company is a conservative or high-risk candidate for options trading. This eliminates the all too common problem faced by traders: Considering themselves conservative but making trades that are high-risk.
In the options world, the question of risk tolerance and methods for picking appropriate strategies and making trades on appropriate issues, should provide the method for making sure risk tolerance affects how decisions are made. This is not practiced by all options traders, and that explains why timing problems arise and why losses occur as often as they do. As long as a conservative trader makes conservative choices, leaving the speculative traders to the willing speculator, the problems of poor selection can be reduced and eliminated.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.