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Eye on Education: Use the expected move before any trade type.
8 min read

Eye on Education: Use the expected move before any trade type.

Eye on Education: Use the expected move before any trade type.

Overview

Last week we looked at an easier way to think about credit and debit spreads. If you missed that check that out here. TL;DR version, they are the same thing, with what side of it you are on determining which side of the risk/reward you are on.

Now for this week's deep dive. Expected moves from the options market. We talk quite a bit about expected move on OptionsEye so I wanted to carve out a post to discuss exactly what it is, and how it can be used to make smarter trades.

TL;DR

The expected move is to options trades what the point spread is to a football bet. You wouldn't place a bet on a football game without knowing who was favored and by how much.

Deeper Dive

Expected move (or implied move) is what the options market is pricing as the consensus potential move of a stock, in either direction, over a period of time. It is derived directly from options pricing and is a practical expression of implied volatility.

If implied volatility increases (based on net buying demand for calls and puts) the expected move increases. If implied volatility decreases (based on net selling of calls and puts) the expected move decreases.

The expected move is direct, and actionable expression of uncertainty. If a stock is about to report earnings, or about to announce trial results of a new drug, there is increased uncertainty of how the stock will react. Once that event passes, the expected move decreases, reflecting an expectation of more certainty.

Here's a good example of that visually, from OptionsAI technology. A 6 month historical chart in SNAP versus its 6 month expected move chart. Note the stock moves on the historical side of the chart versus the earnings lines, then note the expected move widen for the next earnings event in the future:

What that chart is essentially saying is that a large chunk of the future moves over the next 6 months in SNAP are being priced on the expiration immediately following SNAP's next earnings. That curve will actually accentuate that move as it gets nearer in time and more expirations are added closer to the event itself.

Actionable Insights

Aside from the immediate insight of actually seeing when options are pricing big moves, how else can I use the expected move? The expected move is the point at which at the money straddles breakeven. In other words, it is the line at which options are either overpriced, or underpriced, just like the point spread in a football game. If you are buying options and looking for a move higher, you need it to move not just higher, but a certain magnitude higher, just as if you bet even money on the favorite Ravens to beat the Steelers, you need the Ravens to win by a certain amount, not just win.

The expected move should be incorporated into all new trades (including stock) to assess risk/reward and specifically in options trades, to help with strike selection.

Stock

Let's look at a stock example. SNAP is trading near $18.25, let's say I wanted to buy SNAP stock on the hopes that it goes higher by about 10% over the next month or so. I buy it and then put in a GTC order to sell it if it gets to $20. Here's how that looks on the chart:

Here are two trades returned by OptionsAI technology, buying stock, with the gains at my target, and buying stock and selling a call:

The buy-write is selling a call at the expected move, lowering the cost basis and increasing the gains at my target by $40. But I want to dive a little deeper on the risk reward of stock with a target of $20. If we look at the bearish consensus, based on the expected move for that time frame we see this:

In this case the bearish consensus is $15.90. That is $2.35 lower in the stock. Put another way, if I'm correct and SNAP goes higher to my target of $20 over the next month and a half, I would make $174. But if I'm wrong, and SNAP goes lower, the options market is actually telling me my consensus risk is $235. The buy-write has a better profile as it lower the cost basis enough to almost get that risk/reward in line with the expected move.

And that is the second part of the actionable use of the expected move. The strike selection of the call sale. The options market is telling me that that call sale is money I shouldn't be leaving on the table if I'm only expecting a move to $20 or so.

Options

Now let's use the expected move for outright option trade examples and see how it can be used in strike selection. Like we said earlier, the expected move is the actionable expression of consensus in the options market, or implied volatility. If the bullish expected move in July in about 21 in SNAP, and your price target is lower than that, you are essentially saying that you are less bullish than the crowd. If you price target is above that bullish expected move, you are more bullish than the crowd. You are making a judgement on whether options are underpriced or overpriced, even if you don't realize it.

Less bullish than the crowd

Using SNAP as an example again, here's a price target inside the expected move (target $20.30, expected move ~$21), and trades generated by OptionsAI technology to compare:

Let's compare them one by one. The first is simply an at-the-money call. Note the lower probability of profit. That is because that call breaks even at $19.52. Its risk/reward to my target reflects that higher breakeven (not great). The only reason this call could be better than the other trades is it has unlimited potential, in case you're wildly underestimating your bullish expectations. But that unlimited potential will cost you.

On the 18/20 call spread, I am aggressively selling an upside call against my long call, but inside the expected move. That vastly lowers that breakeven (to $18.86) versus the outright call. The potential gains at my target and the increased probability of profit directly reflect that. It's very similar to the buy-write example, if I am less bullish than the crowd, why wouldn't I use the options market to lower my cost, and sell that 20 call?

Here's how it looks on the chart, note the entire trade happens within the bullish consensus, with a breakeven about a third of the way between the current stock and bullish consensus:

And finally, the short 18/16 put spread, it is selling the at the money put, and buying the put on the expected move lower (remember ~15.90 from before.). It's essentially risking the expected move lower, on the reward of SNAP going higher (or sideways). If I'm bullish, but less than the crowd, it is certainly an on-brand way to express that view by selling premium (selling vol) to the bears (they're paying for something I think is both overpriced, and that I don't think will happen directionally).

More bullish than the crowd

What if I think that SNAP can go to $23 in the next month and a half. Here's what that would look like versus the crowd (it's barely on the chart):

And the trades returned by OptionsAI technology:

In this case you see the 18 call again, and two call spreads. The first one, the 18/23 is selling a call at my price target of 23 to help lower the cost of the call buy. It's not much (just 0.14) but again, that's a really bullish price target and the options market is giving that .14 out. Here's how it looks on the chart:

You can clearly see the breakeven, about halfway between the current stock price and the bullish consensus. Profits continue well past consensus.

The second call spread is even more interesting because that sale of the 23 call really sets up a wild risk/reward for an albeit low probability event. The 21/23 call spread costs just $28 but can make up to $171 at my target.

Let's pause on the dynamics of that trade. It's essentially a bet that the crowd has underpriced the expected move. It's playing for a move beyond consensus. Its breakeven is $21.28 in the stock, just above the expected move. It's a lotto ticket for sure, (the 22% probability of profit) but its risk/reward reflects that. Here's how it looks on the chart:

That's a really good visual representation of just how much a bet against the crowd that out of the money call spread is, but how much odds you get for that, the red vs the green.

The Bulls and Bears are both nuts

Finally, what if we decided that the expected move is overpriced, no matter the direction. In that case we're essentially neutral and can look the options market to sell to everyone. Here's a neutral target in SNAP and an Iron condor, selling to both the bulls and the bears, at the expected move. Note the breakevens at the expected move. This trade is establishing a zone within the expected move to profit, and risking a move, in either direction, outside in which case it's a loser. The strike selection is easy, set my breakevens so that I profit if the stock doesn't move by more than either the bulls or bears expect:

The expected move can, and should be a point of reference before any trade. It is the reference point for what you think will happen, where that view stands versus the crowd, and how to best take advantage though strike selection and risk/reward analysis.

See a part of OptionsAI technology with your own price target and demo trades in AAPL HERE

Previously:

Actionable Insights from the Options Market

Earnings event expected moves
Unusual activity alerts
Spread trade education

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