Last update: June 2021
Prepare for a revelatory experience, one that will make you wonder at the wisdom of the crowd and the efficiency of markets. One of the inputs to pricing an option is volatility. Think of it as how much you expect the underlying stock to move. If you expect it to move a lot, then the option price will be high. If you expect to move a little, then the option price will be low.
Said another way, if you know volatility, then you can solve for an option’s premium. And it works in reverse too. If you know an option’s premium, then you can solve for volatility. That is, you can figure out what the expected volatility is based on an option’s premium. Here’s an example:
Stock XYZ will exhibit 30% volatility over the next month. Knowing that information, I can calculate that its one-month, at-the-money call option should be priced at $5.00.
The one-month, at-the-money call option for stock XYZ is trading for $5.00. That implies that the stock will exhibit 30% volatility over the next month.
Key takeaway: you can look at an option’s premium to determine just how volatile the stock is expected to be.
Who sets the option’s premium?
Buyers and sellers, otherwise known as supply and demand. And while one or two traders may be foolish dunderheads, the market in aggregate is pretty good at estimating how volatile a stock is going to be. That means that most of the time option premiums do a respectable job at forecasting how much a stock will move.
If we’re splitting hairs, the market typically overestimates how much a stock is going to move, but that’s a story for another day.
Now, why is knowing how much a stock is expected to move helpful? Well, for a ton of reasons.
A) It can help you place your stop loss a reasonable distance from the current price.
B) It can help you spot price moves that are abnormal or outliers.
C) It can help you decide which strike prices to use when selling options. For example, you can make a bet that the stock won’t move more than expected by selling options with strikes outside of the forecasted range.
The Market Maker Move (MMM) typically shows up before an earnings release and identifies the expected range a stock should trade in with the earnings gap. For example, Costco, which reports earnings on December 14th (this Thursday) has a MMM of $7.33.
That means based on current option premiums, the expected range for COST is $7.33. We can add/subtract that to its current stock price ($188.86) to get an idea of what that looks like on the price chart.
As shown below the upper end of the expected move is $196.19, and the lower end is $181.53.
In case you’re wondering, that doesn’t mean there is a 100% chance that COST will remain in this range through earnings. It represents a one standard deviation move. Essentially there is a 68% chance Costco will sit in the range. That’s the confidence interval. So, if options are correctly priced, and you were to bet that COST would stay in the expected range for the next 100 earnings announcements, you would be right about 68 out of 100.
Do you have to wait until the Market Marker Move feature shows up at the top of your option chain to discover this information?
No!
It’s already displayed for each expiration cycle. That’s what all those numbers are on the right side of the chain. The percentage is the implied volatility for that period, and the number in parenthesis is the expected move higher/lower between now and then. So, for example, the Jan monthly (19 Jan 18) that expires in 39 days has an implied vol of 23.37% which translates into an expected range for COST of up/down $11.62. That means if you were going to sell a bull put spread and wanted to be outside of one standard deviation then you would need to make sure your strikes were at least $11.62 below the current stock price ($188.86).
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3 Replies to “Tales of a Technician: How to use the Thinkorswim Market Maker Move Tool”
Good job Tyler. Very clear explanation of how to apply an important variable.
Thanks Tyler. I knew those numbers on the right must mean something 🙂
thanks for taking time to write this! very helpful. i’ve just one question though…you wrote:
Stock XYZ will exhibit 30% volatility over the next month. Knowing that information, I can calculate that its one-month, at-the-money call option should be priced at $5.00.
The one-month, at-the-money call option for stock XYZ is trading for $5.00. That implies that the stock will exhibit 30% volatility over the next month.
can you please explain how the 30% volatility is related to the one-month, at-the-money call option being priced at $5.00?
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