How to determine if options are cheap or expensive using historical data

[Matt_ORATS]

I want to buy options to place a directional bet. It makes sense only if the options are not too expensive currently. How to find out?

I demonstrate a possible way to solve the problem below, including Python code. I hope that you will point out its errors and shortcomings.

To begin with, I have OHLC historical data.

I could easily calculate the realized volatility for the last year. However, it differs significantly from year to year. It is unlikely that in the subsequent period, it will be very similar to the recent one.

It seems more reasonable to calculate the daily percentage price movements. I have annualized them by multiplying by 252^0,5 to compare with the traded options implied volatility.

I have also calculated the weekly percentage price movements and annualized them by multiplying by 52^0,5.

data['pct_chng'] = (data['Close']-data['Close'].shift())/data['Close'].shift()
# now annualize to be able to compare with traded options implied volatility
data['pct_chng_a'] = abs(data['pct_chng']*100)*(252**0.5)                 
# now do the same for weekly price movements
data['pct_chng_weekly_a'] = (data['Close']-data['Close'].shift(5))/data['Close'].shift(5)
data['pct_chng_weekly_a'] = abs(data['pct_chng_weekly_a']*100)*(52**0.5)
print(data[['Close', 'pct_chng', 'pct_chng_a', 'pct_chng_weekly_a']].tail())

Result:

                                Close  pct_chng  pct_chng_a  pct_chng_weekly_a
Date                                                                        
2023-01-12 00:00:00-05:00  330.130005  0.008770   13.921579          47.569508
2023-01-13 00:00:00-05:00  332.820007  0.008148   12.935045          39.466293
2023-01-17 00:00:00-05:00  326.220001 -0.019831   31.480033          25.282416
2023-01-18 00:00:00-05:00  326.329987  0.000337    0.535210           2.663978
2023-01-19 00:00:00-05:00  315.779999 -0.032329   51.321016          25.295952

After that:

data['pct_chng_annualized'].describe()

count    5200.000000
mean       36.678109
std        43.812184
min         0.000000
25%        10.906413
50%        24.833079
75%        47.330351
max       670.277442

If I use weekly percentage price movements, the result is similar.

data['pct_chng_week_annualized'].describe()

count    5196.000000
mean       40.673958
std        43.129768
min         0.000000
25%        12.736723
50%        28.627616
75%        53.388777
max       530.388741

Let's say options are currently trading with an implied volatility of 54%. Is it correct to conclude that they are expensive because their implied volatility is higher than the 75th percentile?

Is the above approach generally correct?

There are many ways to approach this question. The way we do it at ORATS is to look at:

• ex-earnings IV vs ex-earnings HV (with a good HV like Parkinsons. We have matched this to empirical studies simulating scalping gamma and converting to an HV.)
• Percentiles with ex-earnings IV
• Distributions of stock price moves adjusted for IV
• Forecasts of HV
• Smoothed IV curves
• Comparisons to the best ETF component weighted average.

So it looks like you are looking at NFLX with earnings last night baked into the current IV of 54%. Our two ways to calculating ex-earnings IV or exErnIv30d 44.56 - 47.11. You can see in the graph the significant vol crush after the vertical earnings lines.

https://gyazo.com/89a35af8aa38ffb2f8d3e88fec8215db

The ex-earnigns IV is what you should be calculating a percentile on. You should also look separately at the implied earnings move for the stock. Since there are two moving parts you should try to look at them separately. Here's a look at the implied earnings move.

https://gyazo.com/d844b15eabdd72cce50d28e52928e9ab
Today the market thinks the move will be 8.6% (pre market is about 6.3%), last earnings was 11.8% (it moved 13.1%). You can do a comparison to history to see if that is low or high. You should use the sector to see how other stocks were implying earnings moves. For example, the weighted average for XLY_C (component weighted discresionary) is 5.8% average implied earnings moves, whereas back on NFLXs last earnings 10/18/2022 the XLY_C implied moves avg was 6.3%.

https://gyazo.com/1143732597f3d3a4efae28fe712120d2
We also use distributions to value options. We do an expected return by multiplying the payoff at expiration times the node percentages. Here is a straddle trading $46.78 that we have valued at $39.97 or 14.56% overvalued. Similarly, our forecast based on HV research is $39.94. Both, probably would have worked out. The smoothed curve theoretical is right on the mid market which shows the straddle is fairly priced vs other options in the month.

https://gyazo.com/e7d38cb44148a66e6e8da0d33d64e0a2

 

[ottodickmann]

Thanks. I like the way, you explain.

 

[TheDawn]

There are many ways to approach this question. The way we do it at ORATS is to look at:

• ex-earnings IV vs ex-earnings HV (with a good HV like Parkinsons. We have matched this to empirical studies simulating scalping gamma and converting to an HV.)
• Percentiles with ex-earnings IV
• Distributions of stock price moves adjusted for IV
• Forecasts of HV
• Smoothed IV curves
• Comparisons to the best ETF component weighted average.

So it looks like you are looking at NFLX with earnings last night baked into the current IV of 54%. Our two ways to calculating ex-earnings IV or exErnIv30d 44.56 - 47.11. You can see in the graph the significant vol crush after the vertical earnings lines.

https://gyazo.com/89a35af8aa38ffb2f8d3e88fec8215db

The ex-earnigns IV is what you should be calculating a percentile on. You should also look separately at the implied earnings move for the stock. Since there are two moving parts you should try to look at them separately. Here's a look at the implied earnings move.

https://gyazo.com/d844b15eabdd72cce50d28e52928e9ab
Today the market thinks the move will be 8.6% (pre market is about 6.3%), last earnings was 11.8% (it moved 13.1%). You can do a comparison to history to see if that is low or high. You should use the sector to see how other stocks were implying earnings moves. For example, the weighted average for XLY_C (component weighted discresionary) is 5.8% average implied earnings moves, whereas back on NFLXs last earnings 10/18/2022 the XLY_C implied moves avg was 6.3%.

https://gyazo.com/1143732597f3d3a4efae28fe712120d2
We also use distributions to value options. We do an expected return by multiplying the payoff at expiration times the node percentages. Here is a straddle trading $46.78 that we have valued at $39.97 or 14.56% overvalued. Similarly, our forecast based on HV research is $39.94. Both, probably would have worked out. The smoothed curve theoretical is right on the mid market which shows the straddle is fairly priced vs other options in the month.

https://gyazo.com/e7d38cb44148a66e6e8da0d33d64e0a2

OMG!!!! Exactly the stock that made me lose 25% of my trading capital and you had to pick it to do the analysis. LOL Did an earning play on it few years back. It was making 20% moves during every single earning season for the past like 2 years before so I thought I put in my bet because all of the historical IV pointed to huge earning moves. Did a gut spread too. Lost almost everything on it. As luck would have it, it had a mixed earning that time. For the past two years, every single earning, it was either bad or good with really big directional moves but on that earning that I decided to put in my bet, it had to have a mixed earning. LOL It had good earnings but the revenue was a miss and the guidance was just meh so the stock went up and then went down during AH but I decided to hold it until the next day to see if I can get my 20% like the past 2 years, got totally annihilated by the volatility crush. The stock barely moved like 2% the next day. 25% of my trading capital gone, in one day!!

From that time on, I realized historical and current IV doesn't mean a thing. I mean yeah if I had done a more OTM strangle or longed some kind of back ratio condor, I might have lost less but it would've still been a loss.

Infinite gamma was not happening on that day. It only happens when I am shorting options. LOL

 

[newwurldmn]

OMG!!!! Exactly the stock that made me lose 25% of my trading capital and you had to pick it to do the analysis. LOL Did an earning play on it. It was making 20% moves during every single earning season for the past like 2 years so I thought I put in my bet. Did a gut spread too. Lost almost everything on it. As luck would have it, it had a mixed earning that time. For the past two years, every single earning, it was either bad or good but on that earning that I decided to put in my bet, it had to have a mixed earning. LOL It had good earnings but the revenue was a miss and the guidance was just meh so the stock went up and then went down during AH but I decided to hold it until the next day to see if I can get my 20% like the past 2 years, got totally annihilated by the volatility crush. The stock barely moved like 2% the next day. 25% of my trading capital gone, in one day!!

From that time on, I realized historical and current IV doesn't mean a thing. I mean yeah if I had done a more OTM strangle or longed some kind of back ratio condor, I might have lost less but it would've still been a loss.

TheDawn keeps harping how options are unpredictable and how infinite gamma will kill you
TheDawn claims he earns a lot trading options.
TheDawn loses 25% of his account on infinite gamma in 1 trade.

 

[taowave]

Dawn,I think you know that your bet size on earnings was way way too big..

Nothing to do with vol.You were down 25 percent of your account the next day,on a synthetic strangle(what you call a gut play)??

Sounds like you bet 33 percent of your account on that one play..

i wouldnt jump to conclusions regarding the analysis of current IV and/or Historical Vol due to a trade that went south in a hurry with zero money management

OMG!!!! Exactly the stock that made me lose 25% of my trading capital and you had to pick it to do the analysis. LOL Did an earning play on it. It was making 20% moves during every single earning season for the past like 2 years so I thought I put in my bet. Did a gut spread too. Lost almost everything on it. As luck would have it, it had a mixed earning that time. For the past two years, every single earning, it was either bad or good but on that earning that I decided to put in my bet, it had to have a mixed earning. LOL It had good earnings but the revenue was a miss and the guidance was just meh so the stock went up and then went down during AH but I decided to hold it until the next day to see if I can get my 20% like the past 2 years, got totally annihilated by the volatility crush. The stock barely moved like 2% the next day. 25% of my trading capital gone, in one day!!

From that time on, I realized historical and current IV doesn't mean a thing. I mean yeah if I had done a more OTM strangle or longed some kind of back ratio condor, I might have lost less but it would've still been a loss.

Infinite gamma was not happening on that day. It only happens when I am shorting options. LOL

 

[Option_Attack]

Maybe try this from Larry Mac? Don't know how well it works, but he's been around forever. Doesn't cost very much:

https://www.optionstrategist.com/products/strategy-zone

 

[TheDawn]

Dawn,I think you know that your bet size on earnings was way way too big..

Nothing to do with vol.You were down 25 percent of your account the next day,on a synthetic strangle(what you call a gut play)??

Sounds like you bet 33 percent of your account on that one play..

i wouldnt jump to conclusions regarding the analysis of current IV and/or Historical Vol due to a trade that went south in a hurry with zero money management

True I bet the house on that play but still it was based on the historical earnings moves being at least 10% to 20% with just very few occasions of being at 5%. I mean if the earnings move had been 5%, I would've broken even on that day. So yes overtrading made the loss significant but that overtrading decision was made based on the premise that future IV could be determined and predicted with accuracy from historical IV (Imagine if the earning move on that day had been 20% like how it was for the past 2 years prior like the historical IV, I would be as rich as your option idol!! ) . If I had bet less, I would've lost less but I would've still lost. That's my point.

Are you going to be able to find some kind of correlation between historical IV/Current IV with the future IV? Maybe but all I am saying the correlation is not a reliable one if there really is one.

Ah well, at least you enjoyed my loss porn? Admit it, you enjoyed it...

 

[taowave]

You lost me on over trading..you bought the guts/strangle and "overtraded"??

More to the point,trading vol,directionally or not is vastly different than punting on earning announcements.

There is a reason the "Canslim" crowd steps aside and lighten up pre earnings anouncement.

If anything,play the post earnings vol move or some time spread if the spot vol appears mispriced to the back months. BUT that would require you to adjust your " beliefs",whichmay not be in the cards

True I bet the house on that play but still it was based on the historical earnings moves being at least 10% to 20% with just very few occasions of being at 5%. I mean if the earnings move had been 5%, I would've broken even on that day. So yes overtrading made the loss significant but that overtrading decision was made based on the premise that future IV could be determined and predicted with accuracy from historical IV (Imagine if the earning move on that day had been 20% like how it was for the past 2 years prior, I would be as rich as your option idol!! ) . If I had bet less, I would've lost less but I would've still lost. That's my point.

Are you going to be able to find some kind of correlation between historical IV/Current IV with the future IV? Maybe but all I am saying the correlation is not a reliable one if there really is one.

Ah well, at least you enjoyed my loss porn? Admit it, you enjoyed it...

 

[TheDawn]

You lost me on over trading..you bought the guts/strangle and "overtraded"??

Overtrading = putting in a bigger bet size than what's prudent. Surprised that you have never heard of this term.

More to the point,trading vol,directionally or not is vastly different than punting on earning announcements.

Yes but the reason why I decide to put up the loss porn is because @Matt_ORATS is using exactly the stock that I did an earnings play on thinking that the future IV would be able to be determined by historical IV just to show that in reality, future IV cannot be determined and predicted with accuracy from historical IV regardless whether it's an earning play or 1-way directional play. If it had been a directional play, I would've still lost.

If anything,play the post earnings vol move or some time spread if the spot vol appears mispriced to the back months. BUT that would require you to adjust your " beliefs",whichmay not be in the cards

EXACTLY!! I held the damn gut spread until the next day trying to ride the post-earning vol and that's how I got my huge loss. If I had cashed out during the AH right after the earnings, I could've at least broken even.

 

[taowave]

Overtrading has nothing to do with bet size.You are confusing terminology.

Are you saying you could have delta hedged in the After hours post announcement and locked in a profit??
So it did gap,but you chose to let it ride and it reversed ??

Overtrading = putting in a bigger bet size than what's prudent. Surprised that you have never heard of this term.



Yes but the reason why I decide to put up the loss porn is because @Matt_ORATS is using exactly the stock that I did an earnings play on thinking that the future IV would be able to be determined by historical IV just to show that in reality, future IV cannot be determined and predicted with accuracy from historical IV regardless whether it's an earning play or 1-way directional play. If it had been a directional play, I would've still lost.



EXACTLY!! I held the damn gut spread until the next day trying to ride the post-earning vol and that's how I got my huge loss. If I had cashed out during the AH right after the earnings, I could've at least broken even.