Buy and hold may not be dead. But it’s no longer the straightforward process it was made out to be. It is in fact a brave new world—with short-term holdings, hedging, and derivatives becoming ever more a part of the regular person’s financial lexicon. There’s a cultural perception that the cutting-edge in trading is defined by high-speed quantitative analysis, algorithmic risk modeling, and a barrel-full of ten-syllable words that hardly existed twenty years ago. The technicians are rising it would seem, and the fundamentalists are starting to be seen as, well, fundamentalists.
But this perception has a lot of holes. While it’s true a simple unmonitored portfolio can be a recipe for disaster, the idea that fundamental analysis has been replaced by technical and probability analysis is mostly false. Let’s face it, when all you have is a hammer, all your trades look like nails. So using probability tools in conjunction with a grounding in fundamentals can groom you to become a well-rounded, seasoned market crusader.
Let's take a deeper look at how you can add both fundamental and probability tools into a comprehensive toolkit, without going cross-eyed.
What’s Good for the Gander
As an options trader, fundamental analysis can prove a solid complement to the decisions you’re likely to make. But the reverse is equally true. A solid understanding of probability analysis through the lens of option volatility is invaluable, even if you trade only stocks. Options may seem like voodoo to the uninitiated. But since their worth is tied to the value of the represented stock, options prices can be quite useful to someone trading an underlying security.
Implied volatility (IV) is the foundational building block of most probability analysis. Without pummeling you with the math, expressed on an annualized basis, IV is a percentage representing the market’s expectation of a security’s price range in the future. Notice I didn’t say which direction. Whereas company financials and price charts help determine a stock’s trend, IV helps determine magnitude, or how big the price move might be. So IV and its siblings, “expected move” and “market-maker move,” can be invaluable tools regardless of your trading vehicles. Let’s break down how they work and where to find them.
1—Vol Index is the composite IV for an underlying in the thinkorswim® platform. When in thinkorswim’s Analyze tab, the probable range of a security’s price can be determined for any given date—meaning you can see the expected stock range between any present and future time you select. You can find the Vol Index in a Watchlist column (Figure 1, below), as a snapshot within the Probability Analysis section, or on a day-by-day basis within the Risk Profile section (both on the Analyze tab of the thinkorswim platform).
Keep in mind the Vol Index is a statistical model of price expectation and not a crystal ball. As an equity holder, high vol can reveal when the market expects big stock moves and how big they might be. These date-specific values can potentially be used to help you time portfolio rebalancing, hedging, or trade exits.
2—Expected Move can show you, the equity trader, the dollar value of an expected move by a specific options-expiration date. This is the non-percentage value shown on the far-right side of each options series header (Figure 1 above). While the expiration date doesn’t affect you directly, this kind of benchmark is a great forward-looking indicator to complement traditional charting methods.
3—Market Maker Move (“MMM”) is a displayed value when the volatility of the front-month options expiration is higher than the vol of the next expiration. If displayed, you’ll find the MMM at the top right of the Trade All Products page in a yellow box when an equity is loaded, as in Figure 1 above. If you don’t see the MMM, it is probable that the security is not displaying a MMM value at that time.
When MMM is present, it implies there’s some event in the near term, such as earnings or an announcement, which can shift the price of the underlying security. The MMM is a derived figure that separates the volatility implicit to time from the “extra” volatility attributed to the upcoming event—potentially giving you the amount of movement the market anticipates the event to cause.
Again, none of these figures are tied to a move’s direction. They are merely estimated ranges for a security, given a certain period of time. A stock trader can often use these values to determine when a security might encounter a bumpier ride, thus signaling a time to hedge, a time to build a position, or signal a time to expect a potential reversal.
Let’s look at probability analysis in action by taking a look at high-volatility earnings trades. Picking a directional trade like a long-option strategy, or a neutral trade like a short straddle, using probability tools can complement your fundamental analysis to give you the most complete picture of a potential trade.
Whether your stock moves up or down, vol in near-month options often drops dramatically after an earnings announcement. So overall, option prices tend to move down once vol is removed. This can work to your advantage if you sell premium or work against you if you’re buying. How do you counter this effect? Look at volatility to help determine if the price movement might be large enough (if you’re a buyer) or small enough (if you’re a seller) so that a correct assumption on direction doesn’t turn into a Pyrrhic victory.
The Market-Maker Move above, along with the price of an at-the-money straddle, will help you get a sense of an expected range post-announcement. Since a long straddle is a trade that is profitable when a movement in the underlying is larger than the cost of the trade, it will be priced at or near the value that the market “thinks” the underlying is likely to move.
Reading this value is straightforward. On the Trade page of thinkorswim, set the “Spread” dropdown above the options chain to “Straddle” and look at the price of the strike that is closest to the current market price of the underlying. If the front-month price of this straddle suggests a smaller movement than expected, a long straddle is more likely to pay off than a short straddle if your assumption is validated. If the move inferred by the prices seems improbably large, the short-straddle premium will overshadow delta loss from a movement smaller than that range. Just remember that if you decide on a directional trade, keep in mind that a net-short position will benefit from a vol-drop post announcement and a net-long position will need a larger gain to offset that drop.
Trust the Fundamental Clues
Now that's all well and good once you have a trading idea. But how does one establish an assumption in the first place? Traders can take a look at fundamentals “by the numbers” in the new Fundamentals screen under the Analyze tab of thinkorswim (Figure 2, below). It’s a good way to start hunting for ideas. (Check out Trader Trio for more on this tool.) Looking at previous quarters’ earnings is pretty straightforward. But you should also consider other valuation metrics to get context for that history. For example, a company with a history of beating analyst estimates might be a market darling. But if this rising popularity has caused a price-to-earnings ratio to skew, it may be a sign that expectations are unrealistically sunny. On the other hand, if a company in a slumping industry has been showing growth in market share (viewable in the Company Profile), beating earnings estimates by even a modest amount might provoke a surprising gain because of a perceived flight to quality.
Regardless of the specific scenario, compare a security's earnings history to the price history of the security in that same period to get a sense of established trends. Use your own judgment, along with customized projections in the Company Profile, to plan the move you expect. Finally, compare your analysis to market assumptions using probability analysis, to decide how to best capitalize on your expectations, while keeping your risk at acceptable levels.