WATCH: The 4 Stage Stock Market Cycle


How you can see into the stock market's future. Part II.

By Chris Rowe October 27, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

In my weekly article last Thursday, I told you all about the CBOE Volatility index, which is something that we professional traders watch very closely.

I explained how the "VIX" offers us some real clarity when trying to figure out where a short-term or long-term stock market correction or bottom might be.

I wanted to share a funny comment from one of our readers Mark B, form Long Island NY:

"Chris, thank you for your article last Thursday and for adding such a helpful weapon to my trading arsenal. I feel like I was fighting in the civil war, and you just handed me an M16 rifle."

Thanks, Mark B.

I promised to show you how the historically low VIX is currently presenting us with a huge opportunity to make big profits on options. I'll explain that in a second, but first I want to point something out to you:

Last Thursday I mentioned that when the VIX is lower than 20, it is associated with less stressful, complacent times in the markets.

In contrast, when the VIX is at levels greater than 30 (which is considered high), it is associated with a large amount of volatility due to investor fear or uncertainty.

The majority of the time, this is when you want to buy stocks.

For the last 12 months, the VIX has usually been between 11 and 14, telling us that the market has been very comfortable (with the exception of last October of course, which was the last market bottom, when the VIX jumped to 16 - still not a big deal).

Your "average Joe" investors have had it pretty easy. But last week I told you how to use the VIX to predict short-term market bottoms.

Look at what this latest correction did to the VIX compared to the S&P500. Notice how every S&P500 low correlates to the VIX:

S&P 500: April 1, 2004 - May 24, 2006:

CBOE Volatility Index: April 1, 2004 - May 24, 2006:

The VIX made it up to 19.62 this Monday, from 15.80 when we discussed it last week. And at the time of this writing (Wednesday May 24 at 2:00 pm), the VIX hit a high of 19.87!

The historical spikes in the VIX tell us that this isn't a bad time to nibble on some of your stronger stocks. If the VIX gets to the mid 20s, you should be strong and buy stocks more aggressively.

That is a discussion relating to the short-term stock market bottoms. But on another note, I want to show you why, over the last 2-3 years, we have been presented with a huge opportunity to make big profits with options …

The biggest problem that people have with buying and selling put options and call options is what we call "Time Decay." As you probably already know, as time passes, an option contract loses some of its value, because part of the price that you pay when buying an option is based on how much time the option has before expiration day.

I'm going to really oversimplify here to ensure that everyone gets this important information: Options contracts become more desirable when the market becomes fearful.

That means that people are willing to pay more for options contracts when there's a lot of fear in the market.

Just trust me on this next part: When investors are willing to pay more for a specific options contract in a fearful market environment than they would be willing to pay in a comfortable market environment, it is directly related to investors' willingness to pay more for "time."

So when the market is fearful, they pay a higher price for the time that the option has left on it before its expiration date. Said differently, traders are paying more for "time value."

An easy way to think about it is that Time Value is the extra fluff that traders are willing to pay for an option.

As time passes, that "fluff" part of an option's price naturally diminishes.

Now remember, the VIX measures investor fear because it reflects how much "fluff" is currently "built into" the price of options (or how much extra money traders are willing to pay to protect their portfolios).

When the VIX is at very high levels (around 30), then people are willing to spend much more for a particular option. When the VIX is at low levels (20 or lower), people are not willing to pay as much for the same exact option, which causes options to be less expensive - because they have much less "fluff" or time value.

The amount of "fluff" that options have in them lately has been historically low, even when you consider the recent spike from 11-19 in the CBOE Volatility Index (VIX) this month:

Here's an analogy: The fluff that I'm talking about is similar to the way that investors think of the P/E ratio of your average stock in the S&P 500.

You would be much better off buying stocks when P/E ratios are at historically low levels. You are better off selling stocks when P/E ratios are historically high.

When investors are overly bullish on stocks, or on the growth of publicly traded companies like what we saw in 1999, they are willing to accept that the stocks that they are buying have P/E ratios of 60, 70 or even 130. But we know what happens when the market loses that euphoric valuation and comes back to reality.

When people buy options to hedge themselves against market volatility, people are willing to "pay up" for option contracts. They are willing to pay that extra fluff, or premium. You could say that options are at historically "lean" valuations.

The key here is to understand that time value is prone to "time decay."

I'll explain:

Let's say XYZ stock that trades at $52.50.

Now let's say that you are looking at an option contract which expires in January of 2007, and that gives you the right to buy XYZ at $50.00.

If you have the right to buy XYZ at $50.00, when XYZ is trading in the stock market at $52.50, if you were to use your option contract to buy XYZ at $50.00 and then sell it at the market price of $52.50, then your profit would be $2.50.

That means that the option contract has $2.50 in "intrinsic value." It is basically the tangible value of the option. Time value, on the other hand, is based on the potential future movement of the underlying stock.

Now when you bought that option contract, what did you pay?

Let's assume that you paid $4.00 for the option contract. That would mean that you are paying an extra $1.50 in time value.

(You have a guaranteed profit of $2.50 "intrinsic value." You are paying extra money ($1.50) for the flexibility of exercising the option any time between now and the option's expiration date. )

That is how we decide how much we will pay for an option contract.

We calculate the intrinsic value (here it's $2.50), and then we decide how much we are willing to pay for the right to use the option any time between now and the expiration date (here we are willing to pay an extra $1.50).

After all, if the stock goes to $100.00, then you would be able to use your option to buy the stock at $50.00! And if the stock goes to $20.00, then you only lose the dollar amount that you invested in the option … which is only 4 points!

So you pay a little extra for the privilege and the flexibility of having the potential reward, and limited risk until the option expires.

Let's put this all together now:

As time passes, the time value portion of the price of the option evaporates.

If, by chance, XYZ trades flat at $52.50 for the next 12 months, the option contract would gradually trade lower, and lower, until options expiration day, when the option will be worth $2.50. Assuming that the stock remained at the same price, the lowest that the option would trade to is $2.50.

This is because the time value has evaporated completely. The intrinsic value portion of the option is not affected by time at all.

What does that mean to us?

When investors are fearful, there is more "fluff" - or time value - priced into option contracts. That means the race against time affects the value of your options account in a big way.

When investors are historically complacent (like these days) there is less fluff or time value in option contracts. That means that the race against time is less important, because the portion of the option's price that can evaporate over time is much lower than normal!

In the above example, we were willing to pay $1.50 for time flexibility. But if we were more concerned about what might happen between now and expiration day, we may have been willing to pay $2.00 for the time value on that same exact option (or a total of $4.50 instead of $4.00 for the option).

If we were extremely comfortable with the stock market, we may only be willing to pay $1.00 in time value for the same option (a total price of $3.50 instead of $4.00).

Time decay is an option buyer's worst enemy. But these days, since there is historically high comfort in the stock market, making profits on options contracts is easier than ever!

I hope this helps, and I hope the education makes you a little wealthier.

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