Secret 32 THE OPTION BUYER’S SECRET WEAPON—SHOCK AND AWE

This is one of the most important secrets in the book. Many

option experts have said that option buying is the sucker’s game

and most professionals are option writers. This is partially true. I

love to write options, but option buyers have one secret advantage.

That advantage is surprise volatility. You see, when you buy

options, you are betting on one thing—volatility, movement of

the underlying stock or futures price. If the stock does not move,

you lose!

Volatility is usually pretty predictable and moves in accordance

with a log normal curve (i.e. bell curve). In fact, the Black

and Scholes Pricing Model for measuring the fair value of an option,

which won a Nobel Prize, is based on this curve.

The problem is that the markets do not always move in accordance

with a log normal curve. Chaos theory throws a wrench

in the bell curve theory. Stocks and even futures can make moves

that are much larger than what a log normal curve prescribes.

For example, over the past few years, many stocks have

made 5 to 10 point moves, sometimes more overnight, and on

some occasions dropping over 50% in value, based on unexpected

news, earnings reports or takeover action.

On a log normal curve, there are 3 standard deviations on

each side of the curve, but some stocks move as much as 10 standard

deviations, way beyond the bounds of the curve. Hence, the

pricing model is undervaluing the options, especially the out-ofthe-

money ones at the ends of the curve. In statistical terms, the

tails of the curve are fat.

Therefore, surprise events prescribed in chaos theory can

create instant home runs for option buyers and provide the option

buyer with a secret edge in the game.

One reason for the gigantic moves in stock prices, usually

overnight, is the institutional influence. There are over 4000 mutual

funds, and the institutions truly dominate the stock market.

Hence, when a negative news item comes out about a stock,

the institutions—like a herd of elephants trying to exit through a

small door—try to exit the stock at the same time and cause the stock to show a dramatic drop in price; for institutional managers

do not want to show a losing stock in their portfolio.

In conclusion, when you are buying options, buy options on

stocks that have the greatest potential for surprise volatility. That

would mean tech stocks, overvalued stocks with a lot of hype,

single drug pharmacy stocks up for FDA review, stocks in industries

that are in flux, stocks where you cannot pronounce the

name, and the list goes on, any stock or futures that is vulnerable

to surprise news or events.

This is one of the most important secrets in the book. Many

option experts have said that option buying is the sucker’s game

and most professionals are option writers. This is partially true. I

love to write options, but option buyers have one secret advantage.

That advantage is surprise volatility. You see, when you buy

options, you are betting on one thing—volatility, movement of

the underlying stock or futures price. If the stock does not move,

you lose!

Volatility is usually pretty predictable and moves in accordance

with a log normal curve (i.e. bell curve). In fact, the Black

and Scholes Pricing Model for measuring the fair value of an option,

which won a Nobel Prize, is based on this curve.

The problem is that the markets do not always move in accordance

with a log normal curve. Chaos theory throws a wrench

in the bell curve theory. Stocks and even futures can make moves

that are much larger than what a log normal curve prescribes.

For example, over the past few years, many stocks have

made 5 to 10 point moves, sometimes more overnight, and on

some occasions dropping over 50% in value, based on unexpected

news, earnings reports or takeover action.

On a log normal curve, there are 3 standard deviations on

each side of the curve, but some stocks move as much as 10 standard

deviations, way beyond the bounds of the curve. Hence, the

pricing model is undervaluing the options, especially the out-ofthe-

money ones at the ends of the curve. In statistical terms, the

tails of the curve are fat.

Therefore, surprise events prescribed in chaos theory can

create instant home runs for option buyers and provide the option

buyer with a secret edge in the game.

One reason for the gigantic moves in stock prices, usually

overnight, is the institutional influence. There are over 4000 mutual

funds, and the institutions truly dominate the stock market.

Hence, when a negative news item comes out about a stock,

the institutions—like a herd of elephants trying to exit through a

small door—try to exit the stock at the same time and cause the stock to show a dramatic drop in price; for institutional managers

do not want to show a losing stock in their portfolio.

In conclusion, when you are buying options, buy options on

stocks that have the greatest potential for surprise volatility. That

would mean tech stocks, overvalued stocks with a lot of hype,

single drug pharmacy stocks up for FDA review, stocks in industries

that are in flux, stocks where you cannot pronounce the

name, and the list goes on, any stock or futures that is vulnerable

to surprise news or events.