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How To Use Options To Make Better Equity Trades

Jeff BishopJeff Bishop ·

Crude oil futures prices, along with equity names related to energy have been on an absolute tear lately. This largely came off the announcement that OPEC reached to an agreement to make production cuts. Crude futures nearly gained 10% the day the announcement was made.

But now what?

One great way to get an idea on what traders are expecting is to look at the options market. Now, you don’t have to be an options trader to find this useful.

Let me explain.

It’s been widely accepted by the options community that implied volatility is driven by supply and demand dynamics. For example, the more demand for options, the more expensive they become, and vice versa.

Generally, you have two players, that consists of speculators and hedgers. A hedger might be long stock and might look to protect themselves by buying puts. If there is little to worry about, then premiums will be cheap. However, let’s say the company’s future is uncertain, and it’s stock price is getting hammered. That cost for protection is going to be a lot more.

The greater the perceived risk…the heftier the premium.

Makes sense right? Good.

In theory, there is a 50/50 chance the price of stock will go up or down. With that said, by getting the prices of the call and put strike which is closest to the stock price ( known as at-the-money).

For example, on 12/02/16, the United States Oil Fund (USO) closed at 11.48. Looking at the options they have, the closest strikes they have to it’s market price is 11.50.

In this case we would add the value of 11.5 calls and the 11.5 puts.

The price of the straddle is around $0.47, for options expiring in a week.  If we take $0.47 and divide that by $11.50 we get approximately 4%.

So, if you bought this straddle you would need the market to move at least 4% in one direction in order to break even on the trade. With that said, the market is implying that USO will move about 4% on the week.

(source: www.finviz.com)

So the previous week, USO moved more than 11%, and the market is telling us that things should be calmer. We either grind higher or sell off a little. Well, at least that’s what the price of the weekly straddle is telling us.

Now, if your trading equities you can use this information to possibly set stop levels on trades and size your positions accordingly. Of course, the market could be wrong, and we’ve seen that several times around earnings, where they under price the straddle and stock has a gigantic move.

There are straddle prices for every options expiration period. If you’re day trading or swing trading, it’s good to pay attention to the one that has the nearest term expiration. This is not an indicator, it’s simply the market’s overall expectation. But you can see how it can be useful to make better trading decisions.

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