Today's Know Your Options segment features a very basic explanation of volatility. Liz & Jenny show you why they use it as the staple of all their strategies, and also look at AIG & BHI to exemplify their findings. Tune in to see what they have to say about volatility and its function in the stock option market!

Liz: Hi, everybody. Welcome back to the Liz and Jenny show. I'm Liz, and this is Jenny, and this our Know Your Options segment.
Jenny: That song, it did remind me of … One of my favorite Christmas songs is by Kenny Loggins, and my kids were like, “Who's Kenny Loggins?” So then I bought it, and the picture of him was insane.
Liz: Kenny Loggins brings me back to being like eight years old and sitting in the front of my mom’s car.
Jenny: I'm going to have them try to get this picture to post up so you can see it when we come back at the next break.
Liz: I know who Kenny Loggins is.
Jenny: No, but if you saw this picture you would die.
Liz: The soothing tunes of Kenny Loggins coming up next. This is our Know Your Options segment, so we're going old school with volatility, and we're taking you through it, from step one.
Jenny: Oh, okay, I was thinking we were going to talk about that trade small, trade often, but that's during trade small, trade often. The emailer who sent that last e-mail, we will get to that in our next segment.
Liz: For sure.
Jenny: So know your options, we're talking about volatility, but first we want to talk about the importance of volatility and what it does for your options.
Liz: Volatility is king, legitimately. Volatility is everything for how we trade.
Jenny: Yeah, right.
Liz: It was very similar … and I know nobody needs old trading floor stories … but you know, there's so much stuff here where we didn't have this before. I mean when an option was trading and you needed to raise …
Jenny: Liz is going to talk about when she had to walk up …
Liz: … when you used to trade the volatility, I'd have to punch the button like this, just to get it up. When people were coming in to buy options, you had to be like … try to raise the price of that option with your finger.
Jenny: Right, well, yeah. We had to set the prices of those options so we had to figure out how … and that's exactly right, so this is a good point. If someone's buying options, buying options, buying options, buying options, and you want to make them more expensive, you keep raising the volatility and that's making those options more expensive. So, that's what volatility does. The higher the volatility, the more expensive those options are.
Liz: We couldn't just, I mean honestly with my … we were handcuffed at the time with what we had to work with. If somebody was buying it, I couldn't just be like “Raise that bid to this.” I had to increase my volatility in order to raise that price of my offer. Of the price of the options, both.
Jenny: So as far as being on the floor we would say, “Make that mark at, two and a half, to two sixty, and we would raise that market,” you would yell it out and some person would type it up and put it up there.
Liz: Yeah, but in order to get it in my system, I had to actually raise the volatility.
Jenny: On your computer you'd have to go percentage by percentage and keep raising it to get those option prices set to the right price.
Liz: Jenny started out on the floor as the person that … You would change it. Somebody would be like, "Hey make that two fifty at three bucks." So you'd have to be like two dollars, add three fifty.
Jenny: That was my first job. I was in college, I was a college intern. I stood there at the little keyboard and when people … I was in Tom and Tony's pit, and when people like Tom and Tony would yell out a market I would type it in and it would post on the board.
Liz: Make those June sixty calls too bid.
Jenny: Yeah, so, that was funny, that was a crazy job.
Liz: That was a crazy job.
Jenny: It wasn't hard.
Liz: I was never a quote reporter, I was a runner.
Jenny: You had to have really good hearing.
Liz: I had to run things into the pit and hand them in.
Jenny: I was never a runner.
Liz: You were never a runner?
Jenny: I don't think so.
Liz: It was in the bond room, literally I had to run tickets in, so they'd hand me a piece of paper and I wore gym shoes and I had to run.
Jenny: We've looked ridiculous. Didn't you have an American flag jacket?
Liz: Oh, yeah.
Jenny: An American flag jacket and big Nike gym shoes.
Liz: Looking good at the time.
Jenny: That's why she didn't have a boyfriend back then. So anyway …
Liz: We digress.
Jenny: … back to volatility and why it's so important. Let's look at, let's go to the platform. I went to our market watch, this hasn't been out in a long time.
Liz: This hasn't and I love how simple it is. There's three things on here, you know the high, the low, and the vol index.
Jenny: Well, this is not really set up that properly. I don't even know what it, we don't have the … When I set this up, it didn't have the IB percentile on here, or the rank. But all we need to look at right now is the price of the product. We're going to try to find two products that are the same price and compare their option prices based on their volatility.
Liz: And let's get a relatively higher price to make it crystal clear.
Jenny: Okay.
Liz: Anything over like eighty dollars I think.
Jenny: All right, so if we're looking for something … two products that have the same price.
Liz: Oh, apples … no, that's 113 and 131, sorry.
Jenny: Yeah, same price, same price, I know this is not as high priced but BHI and AIG are both the same price.
Liz: Baker Hughes and AIG.
Jenny: They're products everyone knows. The first products we were looking at today were like triple leverage, double leverage, and we thought, “We don't want to confuse anyone. Let's use products people know.”
Liz: In real time how we got them. Otherwise people would be more confused on why we're using those products in the lesson.
Jenny: So I've sorted the products by price, here we have two products: BHI is Baker Hughs, AIG, they're both almost the same price.
Liz: Perfect, the volatilities are different.
Jenny: Now, here's BHI, it's already there.
Liz: BHI, here we go. So, we're looking at this and we're just compare apples to apples, and we're looking at Baker Hughes, same price as AIG, and we're going to look at the data expirations, just because.
Jenny: And so, we're going to go to the at the moneys. These products are the same price, we're going to use the same amount of days until expiration, 52 days, and what we're comparing is this number right here. That's the volatility. The volatility of those options. Option pricing comes from a few different variables. The stock price.
Liz: The days to expiration and the volatility.
Jenny: And the volatility.
Liz: And the interest rates, but we don't really talk about that.
Jenny: We don't need to talk about the interest rates. Okay, so mostly stock price, days until expiration, and volatility.
Liz: Right, those are the three main components, we know that options are going to be … the fifty- five line is going to be more expensive in February than it is in January, and we know it's going to be more expensive in January 2016 than it is going to be right now.
Jenny: Right, so we're going to compare apples to apples and use the same days until expiration.
Liz: So the main differentiator here between these two products is going to be this, that where Jenny has her yellow arrow. That 36.27%, everything else will remaining equal. We've got the same price options, we've got the same days until expiration.
Jenny: And the same price stock.
Liz: And we've got the exact same strike price. We're going to use the 55 puts.
Jenny: Let's look at these 55 puts. This market here is two dollar bid at 2.66, so mid market is about 230, about 230 is the value of those puts. So if this product is trading 56, 38, and we look at options with 52 days until expiration and we look at puts that are you know a dollar forty below where the options trading. They're worth about 230, so someone might say well, you know if AIG's the same price, and we look at options 52 days to go and we look at puts a dollar forty down, they should be about the same price.
Liz: They should be, if the volatility were the same. Because we just created a new scenario. In a bubble where three of the four things remain equal. So, the only difference is this volatility.
Jenny: And interest rates are the same for both. So, the only difference is the volatility, so let's look at how the difference in volatility.
Liz: Can you leave those things up? And just go to AIG. I was going to say leave the arrows up.
Jenny: Oh, leave the arrows up, that would've saved me a little bit of time.
Liz: It would have been fun.
Jenny: Okay, so now let's go to, we see this is a 36% implied volatility, and that's giving us an option value of 230. Now we go to AIG and…
Liz: Same price, same days to expiration, so we've got wrapped around 56, 70.
Jenny: Price, days until expiration, the difference is this 22 versus 36.
Liz: So that it was a 36 versus 22 so a significant difference. And look what that does to the price of those 55 puts.
Jenny: They're worth about a dollar instead of 2.30. Those other puts are worth 2.30, these are worth a dollar. So why are these worth a dollar and those are worth 2.30?
Liz: Because, when the implied volatility of an option is higher than the pricing of those options become more expensive.
Jenny: So that's why we say over and over and over, it’s more important to trade based on volatility than anything else. It makes more sense to me to trade based on volatility than to look at a chart and say, “Oh, I think this is going up or I think this is going down.” It makes a lot more sense to me to look at volatility and say, “Hey. this volatility is higher than it should be,” or “This volatility is lower than it should be, and let's make our trade based on that.”
Liz: Right, now that being said, we're not saying that we would, that AIG's vol versus Baker Hughes vol, we don't know. So I'm going to look at this right now, and I know AIG is a 56 dollar product. As of right now, I don't know if 22 is high or low for AIG.
Jenny: No, and we're not, but we're not saying, oh we're not going to sell this because this is only a dollar and we're going to sell BHI because that was 2.30 and that's a higher vol than this. We're not comparing volatility of one product the other when we make a trade. When we make a trade we're comparing AIG's volatility to where it is usually, what's the average for AIG, and we're comparing its own volatility. But I think this a good lesson on how much a changing volatility can change the price of an option.
Liz: No, this is an excellent lesson in this but we need to separate the two. So this is just why, when somebody's coming in, and somebody is coming in, when they're coming in to buy those and I think that's the principles that we get, is how we raise the price of something. And when you raise the price of something, it's because somebody's coming in to buy it.
Jenny: It's like supply and demand.
Liz: Supply and demand.
Jenny: Someone’s coming in to buy it, so these option prices go up in value. Just like at Christmas time.
Liz: The hot toy.
Jenny: The 24-dollar Nerf gun going for $300 on Amazon.
Liz: Because people want it, and you can't get a hold of it.
Jenny: Is it worth 300 dollars, no.
Liz: It's worth what people will pay for it.
Jenny: I guess so, I didn't pay 300 dollars for it.
Liz: But it is, that's just it. That's the market. If someone’s willing to pay $300 for it, then that's what it's worth.
Jenny: And so that's what happens with options. More people come into buy it and … just like around earnings, so why around earnings do these prices go up? Because people are coming in and they're buying these options as a chance, they're buying calls because they think it might go up, they're buying puts because they think it might go down, they're buying puts to protect the stock they have. They're coming in and buying all these options and the prices of these options go up, and that's when we love to sell them.
Liz: That's when we love to sell them. Exactly.
All right, so now, we were going to try to go through a checklist, which I don't know that, I don't know want to rush through this, but I do want to kind of drive home the point of … We went through all these and it was an excellent exercise but once again, so just because AIG has a 22 vol, is that high or low for itself?
Jenny: And we haven't even looked.
Liz: We don't know, we didn't look at these yet.
Jenny: If we're looking at options to options, you would say, “Oh, well, it makes more sense to sell the 2.30 than the dollar, but let's look at these products.”
Liz: And maybe it does, maybe it doesn't. Now the next thing to do is to see where it is versus itself, and right down here we keep this visual representation.
Jenny: It's this chart down here, we add implied volatility to our platform, you actually on dough they have this, an implied volatility chart, on the dough platform. So if you're looking on dough, you have this. I know here we have the rank, if you're on dough, the rank is on the page as well. It's on the tile as well. But we need to really … I think it's more important to look at this chart to see, “What is the volatility, where is it coming from?”
Liz: And where are these numbers coming from? So, Jenny put our cursor right where the volatility is right now, right around a 22, which is what we saw, and you can see like, this volatility … and this is what we like to play for is I believe that the volatility is going to revert to the mean way more than the price ever will.
Jenny: So, here's the time when we're going to look to sell options in a product like AIG. One volatility is here, and one volatility is here, and one volatility is here. And then so when we see these spikes, when we see it run up and we watch, and we see this run up, that's when we're going to sell options. We're not going to sell options today, when volatility is here.
Liz: Correct.
So in these terms, we looked at AIG, we looked at Baker Hughes, we didn't look at any earnings information. None of these are trade recommendations. But so, we see this and I would say. “No thanks, I'm not going to sell anything here.”
Jenny: I'm not going to sell anything here today. I'm going to keep an eye on this but I'm not going to sell anything here today.
Liz: That would mean if I wanted to make a play in this I would do something other than just selling premium.
Jenny: You know what I would do in here? I can see that …
Liz:
Jenny: Right. That Earnings are coming up in the Feb cycle. The volatility's not that high yet, we might look to do an earnings set-up because the volatility's not up yet.
Liz: Absolutely.
Jenny: Now, just look at Baker Hughes.
Liz: Very quickly, let's reference the rank.
Jenny: Now, this is a different story. You see the IB rank of 54? You see the volatility up higher than it usually is? This might be a good set-up to sell something.
Liz: I see that earnings are right there.
Jenny: That could be why this volatility is higher.
Liz: Right, and that's what we would expect to see. Versus when we looked at AIG, that earning sub calendar might work because the volatility hasn't started to go up yet, and here I don't know that it hasn't already, look at all of these in the past. The last year.
Jenny: Right, Baker Hughes. One of Liz's favorite products to trade.
Liz: Baker Hughes.
Jenny: All right, so we're going to take a quick break and when we come back we have Trade Small, Trade Often, so stayed tuned.