Did you know that you can get a feel for the value a of stock based on the stock’s option chain? More specifically you can get a read on the short and even long-term opinion of volatility of a particular stock.
This can be a rather complex concept for some, but if you have any questions or comments – leave them and I’ll try to explain.
I am going to compare two stocks, one that is known to be very volatile and one that is relatively low volatility.
The highly volatile stock is S (Sprint) and the low GE (General Electric). I am going to use an expiration of Jan 2013 for both examples.
Let’s first take a look at the option chains for each stock. I want to talk about selling an option on a stock that you own (commonly called a buy-write). I have highlighted the price you would sell the option for in green.
I first want to talk about “in the money” options for GE. “In the money” means that the strike price is lower than the current market price (they have a background color of blue). When you sell a “in the money” option, it’s much like renting your stock out entirely. You will participate in zero gains (since any upward movement will be realized by the buyer), but you usually have a large downside protection. It’s best to look at an example.
GE – Strike $17.50, Expiration Jan 19th, 2013 – Premium $2.70 (14.00% of stock current value)
If you purchased GE stock today for $19.28 a share and sold the option mentioned above you will receive a $2.70 premium for the option, but you paid $1.78 more for the stock than the strike price of $17.50. This means your actual net would be $2.70 – $1.78 = $.92 (4.77% gain). If the stock stays above $17.50, it is assumed the option holder will execute and take your stock and therefore you would have netted 4.77% in 11 months (or earlier if they decided to execute). It does not matter if your stock finished $17.50 or at $5,000 – you will net 4.77%, plus any dividends (this is for a future topic).
Could you get a gain less than 4.77%?
Yes, when the stock goes below $17.50 it hurts your gain. In fact, if the stock went $.92 BELOW $17.50 – you would be at break even. Therefore the stock price would be $16.58 to be at the point that you make 0%. This represents the purchase price minus the premium ($19.28 – $2.70)
Let’s sum it up this way, you receive at a gain of 4.77% (plus dividends) for letting someone else take over your stock until Jan 19th, 2013 – but if the stock tanks below $17.50 – it’s starting to hurt your bottom line and return.
Now let’s talk about how this chain will help you find the value of a stock. You are only getting 4.77% for “renting out” your stock for about 11 months. If the market thought this stock had a good chance of going to $30 within those 11 months, the premium they would be willing to pay would be greater. The market is showing that the valuation of this stock is about where they think it will remain for these 11 months.
Summation of GE Option: What the market is saying is effectively “I will take all of the downside until $17.50 and and any upside of your GE stock from now until Jan 2013 and I’ll pay you $2.70 for that right, and if GE finishes anywhere above $17.50 you will get 4.77% return in 11 months.”
Now let’s talk about Sprint. Go to Next Page.