by Ian Harvey
There are many volatility indicators that exist, and with so many options, it's difficult for the trader to know which indicator or indicators to choose. It's even more difficult to know how to use them well. It is my belief that traders rely too much on the different types of analysis, because “the reality is that they do not work due to incorrect usage, misunderstanding or are just too difficult to apply, and therefore, they are unhelpful in too many instances, and cause a loss to the trader in the marketplace, particularly in the field of options trading”.
Harvey’s Options Volatility Indicator was developed in conjunction with the development of my site “Stock Options Made Easy”, to fill a void in the field of options trading, particularly in determining the direction that a stock will take and therefore the movement of an attached option - up, down or static.
The lack of easy to understand and implement indicators in the marketplace for options trading, led me to create this practical, commonsense-based, more accurate and easy to apply formula -- after obtaining easily attainable information and applying it to a simple to follow table -- for all traders, beginners and professionals, which would provide an edge in gaining profits instead of losses.
Harvey’s Options Volatility Indicator is the key to trading without any stress. As a result of my long-term studies and participation in stock and options trading of markets, I came to the conclusion about the limitations of the possibilities of many volatility indicators, because of their complexity and restrictions.
Simply by following several practical steps, and applying to a table, where the accumulated data, based around information which is easily obtainable through the internet, and other forms of media, Harvey’s Options Volatility Indicator provides a positive, negative or neutral number. An example of the information that is easily available is as follows:-
2. Strike Prices
3. World Events
4. Economic News
6. Market Direction
7. Analyst Opinions
8. Company Information
This information can then be transferred to Harvey’s Options Volatility Formula, which will give a stock direction, and ultimately the options trade to be pursued, by observing the Harvey’s Options Volatility Meter.
This is why Harvey’s Options Volatility Indicator is appreciated by traders for its simplicity and flexibility because it can be used by all levels of traders effectively.
Set-up Before Options Decision:-
Most traders have a set or group of companies, a sector or index funds, which they like to follow – therefore, it becomes easier to keep track of certain information surrounding these companies. However, it is advised to keep an open mind to opportunities as they present themselves – but trying to keep tabs on every company in the marketplace is impossible and would be highly ineffective!
There are several basic steps which need to be employed and a certain amount of commonsense, some simple research via the news media, internet, etc., and adding this information to the table is necessary before applying the information to the formula.
Steps to be Undertaken
1. Selection of Company for an Options Play – There are many catalysts surrounding the decision to select a company, such as:-
• earnings reports,
• analysts opinions,
• economic reports – locally and international,
• political decisions,
• change of company dimension eg. new CEO, stock split, takeover, merger, etc.
• company news – beneficial or disastrous eg. Energy companies suffering an oil spill, a pharmacy company’s latest drug being approved or not,
• recessions, booms, upturns, depressions, inflation
• world power struggles – wars, terrorist acts, takeovers, threats,
• and major catastrophes such as earthquakes, tsunamis, hurricanes, which will all have an effect, positively or negatively on the company associated with this decision,
.....to name just a few. Once the decision has been reached as to which company to pursue then the next stage on this checklist can be taken.
2. Market Direction – is the market moving up, down, ranging or in limbo? – A look at the previous five (5) closes is a fairly simple indication and will help determine the direction the market is taking.
3. Stock Direction at Present – this is fairly straight forward – a look at the stock chart for the past three (3) months will certainly help determine this direction. Obviously there will be the usual volatility experienced but an overall pattern can be ascertained.
4. Volume/ Sentiment -- The stock price will now determine the strike price to be considered. Round numbers have always been considered an appropriate point of consideration, but this does not always prove totally effective particularly for smaller priced stock. Also, there is the decision of the trader to determine the length of time before the option expires. When I provide member recommendations, I usually look at a time frame of three (3) to six (6) month expiration dates, as well as the cost of the options trade.
5. Internal Stock Influences – what are the driving forces behind the direction of this stock either encompassing positive or negative implications? This may entail many factors, such as earnings reports, analysts upgrades or downgrades, re-organization of the company structure, mergers, take-over pending, company news - either for good or bad – such as extra goods orders, expansion, major problems associated with the company, etc.,
6. External Influences – as mentioned in Step 1 – natural disasters, political decisions, economic reports, wars, recessions, etc.,
7. Final Calculation – by adding the positive and negative points and then applying the end result to “Harvey’s Volatility Meter”, the trader is able to obtain a reasonably accurate feel as to which direction the stock is moving and therefore adopt an appropriate options trade. Obviously the strike price will vary according to the trader’s timeframe!
MD + SD + V/S + II + EI = OD
MD = Market Direction
SD = Stock Direction
V/S = Volume/Sentiment
II = Internal Influences
EI = External Influences
OD = Options Direction
Harvey’s Options Volatility Meter
Application of the Formula….using an Example -- Mattel, Inc. (NASDAQ:MAT)
Now, to understand the simplicity of Harvey’s Options Volatility Indicator, take a look at the simple steps taken to determine if an options strike will be positive, negative or static on the example, Mattel, Inc., Company, which in turn will provide the options strike applicable. The information used here is easily obtainable from the internet.
Step 1. Determining the reasoning behind the selection of Mattel is apparent when looking at an earnings report that is due in a few days, there has also been an analyst downgrade, internal management problems, as well as the overall market direction being in a slight downtrend.
Step 2. Market Direction -- for the past week the major indexes have been on a downward decline – the Dow Jones Industrial Average (DJI), the S&P 500 Index (SPX) and the Nasdaq Composite (COMP) declined between 2.4% and 3.1% for the week, whereas, the CBOE Volatility Index (VIX) advanced 22% during that time.
Step 3. Stock Direction – Mattel has been suffering a downward spiral due to a previous disappointing quarter and is not expected to provide much positive news for the new earnings report. Since the overall trend is away from traditional toys in favor of online games and mobile gaming, which is something that Mattel has not yet been able to master. The company is dealing with declining sales for its biggest brands Barbie, Fischer Price, and Hot Wheels, and until it is able to boost sales of these brands the stock is going to remain depressed. An earnings beat could add a little strength to the stock, but the long-term outlook will remain weak regardless of any positive earnings surprise.
Step 4. Volume/Sentiment – Overall, options traders are gambling on a pullback for the shares, with puts trading above the normal pace with short-term options growing increasingly popular with volume outstripping open interest -- all signs of newly bought bearish bets.
A look at the previous day’s options trades gives a more mixed picture showing that calls have exceeded the put volume for this particular day, but the put prices have increased showing that interest is more applicable….
Table 1—Call Strikes
Table 2 – Put Strikes
Step 5. Internal Influences – There are several catalysts that may affect the movement of this stock:-
1. Earnings report due --- previously discussed in Step 3.
2. Analysts downgrade --- BMO Capital Markets downgraded Mattel from a “market perform” rating to an “underperform” rating and currently have a $33.00 price target on the stock, down from their previous price target of $40.00. BMO Capital Markets’ price target would indicate a potential downside of 16.26% from the stock’s previous close.
3. Senior managers in the Indian operations, which also included the country head Karen Gera, quit, which upsets the confidence among stakeholders.
Step 6. External Influences – this involves in-country as well as internationally….such as:-
1. April 15 tax deadline,
2. Delta-hedging effect,
3. Growing short interest,
4. China’s economic problems,
5. Effect of cold weather, and
6. Retail sales are up.
Step 7. The Calculation – firstly, this involves using the table to arrive at a figure combining the catalysts, events and influential measures that will or have affected the stock price.
Next, apply this information to Harvey’s Options Volatility Formula…
MD + SD + V/S + II + EI = OD
-1 + -1 + 1 + -3 + -4 = -8
Therefore, according to the “Volatility Meter”, Mattel is a good candidate for an “Options Put” play. Obviously the selection of this “Put Option” will depend greatly on the trader’s suitable time-frame and cost acceptance.
It is important to remember that a too in-depth study of the stock is not always beneficial in reaching a trade decision, as this will, at times, become even more confusing. A decision as to the crucial points is necessary, however, if certain information is not available or unattainable then a limited checklist will certainly provide the basis and a feel as to whether the stock is likely to move in a particular direction. Obviously, if this cannot be determined satisfactorily, then maybe, this is not the options trade to be pursued.