Buying an option is a completely different match than buying a stock, in part because of the time value component of the option price. While a vanilla stock trader only needs to be correct in the direction of the stock price, the option buyer needs the expected stock to function for a fixed period of time – and this move needs to be large enough to offset the negative impact of the time decay option value.
Implied volatility (IV) is a key component of time value and reflects the market's expectation of how much volatility an option achieves throughout the option. Internally, we use an indicator called the Schaeffer Volatility Scorecard (SVS) to help us identify stocks that regularly make larger price changes, rather than their option IV levels.
SVS works by measuring the volatility of stock realization and the volatility expectations of the price pricing of the stock in the past year. Therefore, it helps determine which stocks are best for quality buyers in history – and the worst.
The indicator is calculated by creating a hypothetical intra-price straddle transaction that expires for 21 days on each trading day of the year – generating approximately 250 data points per year – where IV is derived from the actual in-the-money option . Assume that the leap expires, and when it is closed due to intrinsic value, the assumption is crossed.
The 250 hypothetical straddle returns per inventory per year are used to calculate the SVS value, which takes into account three weighting criteria: 40% based on the average straddle return; 40% based on the percentage of positive returns; 20% based on the straddle IV Percentage ranking. These metrics are then combined into a score from 0 to 100.
High SVS readings (up to 100) indicate that stocks have consistently offered higher returns than their IV option forecasts, which means it may be a strong candidate for future quality buying strategies. A lower SVS reading (always down to zero) points to a stock that has consistently achieved a volatility below its option price – pointing to a possible high-priced sell candidate.
However, it is important to remember that SVS does not necessarily predict future results because it is a lagging indicator. Instead, we'll look at SVS and simultaneous volatility metrics—such as 30-day parity IV and the entire term structure—and combine that analysis with our usual technical and emotionally driven criticism to determine the strongest option buy opportunity. Possible stock.
To learn more about identifying options trading, check out the primers for implied volatility. To prepare for the earnings season, be sure to read the information about this option strategy.
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