Text size

Uncertainty has returned, after many years of tame equity market behavior.

Even though stock indexes have rebounded from their recent pyrotechnics, options volatility remains elevated. It’s a sign that the options market is taking a Ronald Reaganesque “trust, but verify,” stance toward equities.

Newsletter Sign-up Review & Preview Every weekday evening we highlight the consequential market news of the day and explain what's likely to matter tomorrow. PREVIEW

Wall Street, as it often does in such moments, has become something of a tower of Babel. This strategist or that fund manager wants investors to buy all dips and many stocks. This pundit or that analyst thinks the recent historical swings in the stock and volatility markets are harbingers of doom.

Perhaps everyone is right, and no one is right. It doesn’t really matter.

Instead, it is important to maintain some personal equilibrium, and to establish a frame of reference to size up where we are, and where we might be going. And this, dear investor, is why it is critical to understand the Rule of 16. We have discussed this before, but it is time for a refresher because this simple trader’s trick helps separate fact from fiction.

THE RULE OF 16 tells us how options are pricing a stock. If implied volatility—that is what the options market thinks will happen in the future—is 16, it means the stock is priced to move 1% each day until expiration. At 32%, it means a 2% move and so on. You can essentially determine implied volatility by measuring how a stock has traded in the past and estimating how it might move in the future, based on a variety of factors, including interest rates, time to expiration, and events that could move the stock. The measure is readily available on many brokers’ online sites.

Doing the simple math to determine if options premiums are cheap or not will lead to an important question. Do you think the security will move more or less than the amount priced by the associated put or call? If you think not, consider selling the options. If you think so, consider buying them.

If you don’t trade options, use the Rule of 16 to see what the options market is pricing. Regardless, do not trade options on stocks you don’t want to own. Leave volatility trading to institutions.

Let’s use Alibaba Group Holding (ticker: BABA) as an example. Recently, the shares retreated from a 52-week high of $206.20 to about $187. Implied volatility was about 32% for the June $190 calls that will capture the next earnings report, expected in mid-May. The call, trading around $13.80, is priced as if it would move about 2% until expiration. The contract is priced around Alibaba’s 200-day volatility average of 31%. If all goes as hoped, Alibaba would trade to a new high. If the stock hit $220, for example, the call would be worth $30.

Bottom line: Options are packed with information, and should be used by investors to refine their thinking about the market.

GARY KATZ, WHO HELPED introduce electronic trading to the U.S. options market, will receive one of the industry’s highest honors.

The Options Industry Council, representing exchanges and the Options Clearing Corp., named Katz as the 2018 recipient of the Joseph W. Sullivan Options Industry Achievement Award. It will be presented at the 36th Annual Options Industry Conference on May 2 on Amelia Island, Fla.

Katz is the former president and CEO of the International Securities Exchange, now owned by Nasdaq (NDAQ). Mary Savoie, OCC’s first vice president of industry services and executive director of OIC, praised Katz for helping to create the first electronic options exchange, and for enhancing market efficiency.

By the time Katz ended his career, trading floors had been replaced by electronic trading systems, and the options market was more efficient and fair than before.

STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

Comments: steve.sears@barrons.com

Follow: @sm_sears