How the options market predicts future price moves

by Derek Moore on January 31st, 2014

While it’s not possible to get tomorrow’s stock market prices today, you can look to the options market to understand how far a stock may move up or down using an underlying’s Implied Volatility or I/V. In fact last night the options market is predicting a about a 1% move + or - in the S&P 500 Index. Wanna know how we did that?


With us in the midst of earnings season we’ve see what a big driver of price missing or crushing estimates can be. Other things that drive quick price moves are product announcements, FDA announcements, CEO’s being sentenced (more on that later). When big news is on the horizon, traders anticipate price will break even if they are not sure what direction.


Indexes, stocks, ETF’s, futures all have an implied volatility and a historical volatility. Historical is just that. It looks backwards and can tell us how volatile a stock has moved over a period of time. The option market’s expectation for future price movement is expressed in an underlying’s implied volatility. The more traders believe a stock will move, the higher the I/V.


To illustrate let’s examine the S&P 500 Index (SPX). The February options at the close today were trading with an implied volatility of 15.84%. Remember the higher the volatility percentage, the greater the expected move up or down. But what that number really represents is how much a one standard deviation move might be over one or many days.


Yes folks, we are talking about the dreaded bell curve! You remember from high school where you learned results will be within 1 standard deviation 68% of the time. And to know what a 1 standard deviation move will be tomorrow you need the following steps:

There are 252 trading days in the year. The square root of this equals 15.875. If your more inclined to do this in your head, feel free to cheat a bit and round up to 16.

Now you will take the underlying’s I/V % and divide by 15.875 to get the 1 standard deviation move for the next day.

Let’s go through a few examples to illustrate.

SPX I/V = 15.84

15.84/15.8745 = .997% (Go ahead and round up to 1%)

Netflix reported earnings last week. The day prior:

NFLX I/V = 149.27%

149.27%/15.8745 = 9.4% 1 day move expected!

Finally, we’ll reach back into the archives. Back in 2004 Martha Stewart was due to be sentenced in the insider trading case. Right before sentencing was announced:

MRO I/V = 339.01% WOW!

339.01/15.8745 = 21.36% expected move up or down in 1 day!

Now the move could wind up being more or less than expected. What we can see though is what the options market through the pricing of options is saying they believe a range might be. Many trading platforms will show you what the probability range.

Above we see the SPY etc. You’ll notice that as you move further and further out along the options expiration calendar, the probability cone widens. You might be asking yourself how to figure out the expected move not only for 1 day, but multiple days or months. It does get a bit tricky because each months options carry a different I/V, but in general if you follow these steps your’ll get a good idea.

 

Take the SPX Index with a 1 day move of 1%. Say you wanted to know based on the SPX current implied volatility what the options market is forecasting over the next 49 days? Simply take the square root of 49 which is 7 (now you see why I choose 49 days) and then multiply by the 1 day expected move.

 

So 7 x 1 = 7%.

 

Options traders are essentially either buying or selling volatility to some degree. As we continue through earnings season, keep an eye out for the expected move and then see which stocks moved more or less that the market thought.



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