Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Tom Gentile of Optionetics
INTEREST RATE INDEXES
The five-year note index (FVX), the 10-year note index (TNX), and the 30-year bond index (TYX) are vehicles to trade options on interest rates. My question is, what are the corresponding bond price indexes, and are they optionable? Thank you, Tom - your monthly "Explore Your Options" page is always riveting. - Fiorenzo Primavori
The five-year note index ($FVX), the 10-year note index ($TNX), and the 30-year bond index ($TYX) are vehicles some traders use to monitor and profit from changes in interest rates. The indexes actually represent the current rates on various government bonds multiplied by 10. Thus, the 10-year note index reflects the current rate on the benchmark 10-year Treasury note, multiplied by a factor of 10. If the yield on the 10-year note is 4%, the TNX will equal 40. Similarly, the 30-year bond index tracks the yield on the 30-year Treasury bond, and the five-year note index is the yield on the five-year note, times 10.
Options are available on the interest rate indexes, and traders can use them to participate in the future direction of bond prices and rates. The rate indexes will actually move opposite to bond prices. So, when the 10-year Treasury note falls in price, the TNX will move higher. If traders expect rates to move higher, they might buy calls or set up bull call spreads on the FVX, TNX, or TYX. It is important to note, however, the options on the rate indexes do not see a great deal of trading activity. As a result, they lack open liquidity and the spreads between the bids and offers are often wide.
As an alternative, traders can participate in changes in the bond market with the iShares Bond Funds. In April 2003, the Chicago Board Options Exchange (CBOE) and the American Stock Exchange (AMEX) both announced the launch of options on the iShares Lehman 20-plus year Treasury bond fund (TLT), the iShares Lehman one- to three-year bond fund (Shy), and the iShares Lehman seven- to 10-year bond fund (Ief). All three funds hold government bonds, but each is different in terms of maturity. For instance, Shy holds short-term notes that mature in one to three years, but TLT holds long-term bonds like the 30-year Treasury bond. These funds, particularly the TLT, tend to see more trading activity and therefore more liquidity than the TNX, FVX, or TYX.
LONG-TERM HISTORY OF IMPLIED VOLATILITY
Rampart (http://www.rimco.com/indexes.html) provides graphs of the long-term history of the implied. They use an index that measures and aggregates the cap-weighted volatilities of each of the 100 stocks that make up the Standard & Poor’s 100 index. This is a far more accurate portrayal of how expensive or cheap options in general are, compared to the Vix, which is institutionally dominated and subject to arbitrage. Ivolatility.com provides one-year data, and McMillan gives some raw data that is difficult to use, but is appreciated. Do you know where there is information on the long-term history of the implied of liquid, large-cap stocks? This is, I think, the best indicator of whether to go short, long, or stand aside. Illiquid small-caps often become expensive because someone knows something. How important do you think this is? Thank you - Raymond McLaughlin
Knowing whether implied volatility (IV) is high or low is extremely important in options trading. If it is low, options are cheap, and if it is high, options are expensive. It is better to be an option buyer (as with a straddle purchase) when options are cheap, but IV is expected to move higher. However, it is better to sell options, as with the covered call, when IV is high and expected to fall. Basically, knowing whether options are cheap or expensive can help improve the risk/reward ratio of the options trade.
In addition, as you said, the CBOE volatility index ($Vix) is not always the best gauge of whether implied volatility in the market is high or low. The reason is that Vix measures the volatility of Standard & Poor’s 500 index ($Spx) options. Similarly, the $Vxo measures the IV of S&P 100 index ($Oex) options, and the $Vxn tracks the volatility of Nasdaq 100 index ($Ndx) options. However, the volatility of index options might be significantly different from the volatility of individual stock options at any given time.
In order to find the history of implied volatility for individual stocks, you can use a service such as the one we provide at Optionetics.com to create long-term implied volatility charts for a stock or index. This will let you see graphically whether IV is high or low relative to the past. In addition, you can use an options ranker that will screen for options with high and low implied volatility. This can help you find the cheapest and most expensive options at any given time.
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Originally published in the October 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
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