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Chart Studies for Options Traders

Chart Studies for Options Traders

Key Points
  • Are the options you're considering relatively cheap or expensive?

  • Are options traders establishing more put or call positions?

  • Get these answers and more with our four new chart studies.

Schwab has four new chart studies designed especially for options traders. Three of these studies compare implied volatility (calls, puts or average) to the historical volatility of an underlying security. The fourth chart study shows the open interest put/call ratio, which can be a helpful measure of options trader sentiment.

In order to fully explore the benefits of the new chart studies, let's quickly review volatility as well as an older chart study.

Volatility

Volatility is probably the most overused and least understood options term, yet in my view, a basic understanding of volatility is almost essential if you want to become an experienced options trader. Volatility is one of several components that affect the price of an option, and a relatively small change in volatility can have a relatively large impact on the option price.

There are two main types of volatility:

  • Historical volatility measures a stock's actual price movement over a specific period in the past.
  • Implied volatility is an estimate of where a stock's price may move going forward.

Historical volatility chart study

The Historical Volatility Study displays the historical volatility of a particular stock or ETF. Since the historical volatility of a security is factual data, it shows the actual volatility of the security. If you left-click while in the chart window, the study displays the historical volatility calculated from the date where your cursor appears, backwards by the number of days you've specified. In the example below, "HV (30): 24.30”(at the top of figure 1 below) indicates that the stock had a 24.30% volatility over the past 30 days.

Typically options traders compare the historical volatility of the underlying security (light blue line) to the implied volatility of the options on that security, to help gauge whether an option's price is currently above or below "normal" levels. Of course, what's "normal" is a relative term and changes over time depending upon the security, strategy, time horizon and market conditions.

Figure 1

Figure 1 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

There's a fairly popular options theory called "volatility mean reversion." This theory states that over a short time frame stock prices can be either erratic or calm. When prices are erratic, they'll move to extreme levels to the upside or the downside. However, when stock prices are temporarily more erratic than normal, they eventually tend to revert to their long-term averages.

For example, if a stock has had a volatility range of 60% over the last 30 days but had a volatility range of 30% over the course of the past year, this theory predicts that volatility will eventually decrease. As volatility is a nondirectional measure, this theory can also be applied when volatility is less than normal. In other words, if a stock's price has been exceptionally stable over the past month, the theory predicts that it could become more volatile as it moves back toward its average annual volatility.

Implied volatility chart studies—what they can do for you

If you believe in the volatility mean reversion theory and you had a way to compare the implied volatility to the historical volatility (depending upon your time horizon, strategy and market outlook), you might be able to form an opinion about whether the current level is higher or lower than "normal." Using three volatility chart studies, you can compare the implied volatility of the calls (green line in figure 2), puts (pink line in figure 2) or an average of both (red line in figure 3) to the historical volatility of the underlying security (light blue line in figure 2 and figure 3) and determine the manner in which the two typically relate to each other.

Figure 2

Figure 2 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

These studies can be displayed in a separate window at the bottom of your chart (shown above) or as an overlay (shown below). The chart above illustrates the implied volatility studies for calls and puts individually (green and pink lines), while the chart below shows the average of the two (red line).

Figure 3

Figure 3 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

Also, you can smooth out the lines for longer-term trend analysis using a simple moving average of the implied volatilities (purple and orange lines in figure 4) over the period of time you specify. When you add the Studies from the chart settings menu on the right side of the chart, you''ll have the ability to set the moving-average time period.

Figure 4

Figure 4 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

By charting past levels of both implied and actual (historical) volatility, you can tell whether a stock's implied volatility accurately forecasted the actual volatility. For example, implied volatility will often spike just before earnings reports, yet the actual volatility of the stock after the earnings are released may be less than what was implied. By contrast, when unexpected news reports (such as takeover rumors) come out, actual stock volatility may reach a level far exceeding that forecast by the implied volatility just days before the news.

Since the function of implied volatility is to anticipate the actual stock movement, this type of information may help you determine if calls, puts or both are currently pricing above or below "normal" levels, relative to the price and volatility of the underlying security. While the relative levels of implied volatility and historical volatility will vary and are often affected by earnings reports, anticipated news events and overall market volatility, these new studies will give you a way to analyze what's considered "normal" for a specific security. Since unusual activity may indicate pricing irregularities, trading opportunities or even insider activity, once you're comfortable with what you believe is normal, you may find ways to take advantage of potential abnormalities.

For example, when implied volatilities on options are lower than normal, options prices may be relatively cheap. With this information a trader might choose to establish a position using an options strategy that would gain value if volatility increases. For instance, most options strategies involving long options (or more long options than short options) will gain value if volatility increases. Therefore, you might want to consider some of these strategies: long puts, long calls, long straddles, long strangles and ratio backspreads.

Out-of-the-money debit spreads and in-the-money credit spreads also will generally gain value from an increase in volatility, but to a lesser degree, given that the gain in value on the short leg will partly offset the gain in value on the long leg. Other possible strategies that might benefit from an increase in volatility include above-the-money collars, below-the-money reverse collars, short butterflies, and short condors.

This same approach can be effective in reverse, too. In other words, when the implied volatilities are relatively high, there may be opportunities for short strategies that lose value if volatility falls (such as short puts, short calls, short straddles, short strangles and ratio spreads). A decrease in volatility on these strategies may allow you to close them out for less than they were originally sold.

Likewise, in-the-money debit spreads and out-of-the-money credit spreads might also gain value from a decrease in volatility, though the gain in value on the short leg will partially offset the gain in value on the long leg.

For example, when volatility goes down, an in-the-money debit spread will gain value because the value lost in the long option will be less than the value lost in the short option. Take a look at the following example where the price of XYZ is $85.50.

  • Buy 1 XYZ Mar 80 call @ $6.60; the current implied volatility is 30
  • Sell 1 XYZ Mar 85 call @ $3.00; the current implied volatility is 28
  • Entering this spread will cost a net debit of -$3.60
  • If the implied volatility component of the pricing model drops by exactly 10 points on each option (to 20 and 18, respectively) and there are no other changes, the price of these options will be approximately: XYZ Mar 80 call @ $5.85; a reduction in price of -$0.75 and XYZ Mar 85 call @ $2.05; a reduction in price of -$0.95
  • Exiting this spread will result in a net credit of +$3.80

Because the short option dropped by more than the long option, the net value of this spread is positive to the holder.

At-the-money or in-the-money buy/writes (sell/writes) may also benefit from a decrease in volatility, since that could present opportunities to close out the short calls (puts) at a lower price than they were sold for without requiring a significant drop (gain) in the price of the underlying stock. Other possible strategies that might benefit from a decrease in volatility include below-the-money collars, above-the-money reverse collars, long butterflies, and long condors.

While going long on a stock may allow you to profit from stock price increases, and going short on a stock may allow you to profit from stock price decreases, certain options strategies may give you the opportunity to profit on stock price volatility in either direction, which is something you simply can't do with stocks alone.

Put/call ratio study can help measure sentiment

While the put/call ratio (based on volume or open interest) for any optionable stock has long been available in the trading window on StreetSmart Edge (figure 5 below), you can also display a chart study of the open interest put/call ratio.

Figure 5

Figure 5 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

Open interest is not calculated during the day or by the individual option exchanges; rather, it's calculated each night by OCC (formerly known as the Options Clearing Corporation) once the day's trades from all exchanges are matched. While OCC posts the aggregate open interest levels each day, until now you had to use an alternate source or gather your own statistics if you wanted to see increases and decreases in open interest over a period of time on individual securities.

There are far more option strategies that involve holding a contract over a period of time instead of trading intraday, so a historical record of the open interest put/call ratio may be helpful in determining the longer-term sentiment for a particular equity. Because the open interest indicates the number of contracts outstanding, it can be a helpful measure of options trader sentiment over a given period of time.

Like the volatility studies, the put/call ratio study can overlay your equity chart or appear in a separate window below it. Also, you can view either the day-by-day values or smooth out the line as a moving average over the period that you specify.

Figure 6

Figure 6 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

While different securities behave in different ways, put/call ratios are often considered contrarian indicators. In other words, a relatively high ratio (more puts than calls outstanding) is often considered bullish, while a relatively low ratio can be a sign of bearishness. Through my own research, I believe this contrarian indicator may be more accurate for indexes than for equities, but with this study, you can examine the past behavior of any optionable equity, ETF or index even at extremely high or low put/call ratio levels.

How to locate the studies

Both the volatility and put/call ratio studies are found within the chart settings menu of the charts in StreetSmart Edge®.

In StreetSmart Edge, the studies menu can be accessed by clicking on open/close arrow from the right side of the chart, and then clicking on "View All Studies" as shown in figure 7.

Figure 7

Figure 7 Chart

Source: StreetSmart Edge®
Symbols and market data shown are for illustrative purposes only.

From the Studies menu, you will see the put/call ratio studies and implied volatility studies located under the "MarketStrength" and "Volatility" categories respectively (figure 8). Once you have selected one of the studies, you will have the option of displaying the selected study in Actual or SMA mode. If you select SMA mode, you can enter a period value between 2 and 200 for the moving average (default period value is 20).

Figure 8

Figure 8

Source: StreetSmart Edge®

A few notes of caution

Implied volatility: Normal levels of implied volatility will not only vary from stock to stock, but, as noted above, also on a single stock over different time periods. The volatility mean reversion theory will often only hold true if all factors return to where they were before the volatility got "out of line." Basing the conclusions of any volatility research on the belief that the markets will eventually return to "normal" levels may not be wise if your idea of normal differs from what is considered "normal" in the overall marketplace.

Put/call ratios: Don't confuse open interest put/call ratios with volume put/call ratios, both of which are available in the StreetSmart Edge trading window (see figure 9).

Figure 9

Figure 9

Source: StreetSmart Edge®

Open interest ratios are calculated based on the number of outstanding put and call option contracts at the end of any given trading day. Volume ratios are calculated based on the volume of intraday puts and calls trading on any given day. Opening trades increase open interest and closing trades decrease open interest, so it's impossible to know during the day whether trading volume will increase or decrease open interest. Volume ratios tend to react much more to the "news of the day" than open interest ratios.

Also, be aware that open interest tends to drop sharply after each monthly option expiration due to the large number of front-month (current-month) contracts that are expiring. This will often be visible on the daily open interest put/call ratio chart, but can largely be smoothed out using the moving average study. This effect is even more dramatic each year after the January expiration, due to the large number of LEAPS (long-term equity anticipation securities) options that are also expiring.

Historical volatility (HV)

Historical volatility is the actual statistical measurement of a stock's past price movement. It's calculated using an annualized standard deviation of percent changes in prices over a specific time frame. Historical volatility is sometimes called statistical volatility.

Implied volatility (IV)

Implied volatility is the theoretical volatility of the underlying stock, ETF or index, based on the quoted price of the options of that particular stock, ETF or index.

Implied volatility is computed using a theoretical options pricing model such as Black-Scholes, Barone-Adesi-Whaley, or Cox-Ross-Rubinstein and solving for the unknown volatility component. Since volatility is the only component of a pricing model that is unknown, it is possible to work the formula backwards and calculate the implied volatility estimate being used by the options market maker. It can also help to gauge whether options are relatively cheap or relatively expensive. Rising implied volatility causes option premiums to rise or become more expensive; falling implied volatility results in lower option premiums. To solve for implied volatility, option pricing models use the following information:

  • The option's expiration date (higher value increases calls and puts).
  • The strike price of the option (higher value decreases calls and increases puts).
  • The price of the underlying security (higher value increases calls and decreases puts).
  • The annual dividend yield (higher value decreases calls and increases puts).
  • The prevailing risk-free interest rate (higher value increases calls and decreases puts).
  • The option's current price (available from the quote screen).
  • The expiration style (American or European).
  • The option type—call or put (calls move with the underlying security, puts move opposite).

Next Steps

Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
Not yet a client? Learn more about Schwab Trading Services.

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