My knowledge of options is basic. I understand strike price and the time value/intrinsic value distinction. I understand expiration dates and the concept of time value decay. I understand that volatility is key in determining time value.

I have heard the phrase "Buy options when volatility is low, sell when volatility is high." My question is how best to implement this strategy.

Hypothetical:

Stock closed at $59.50 on August 1. You expect it to reach $70 within the next 4-6 weeks. Bollinger Band width is near a 6-month low. You expect BB width to double or triple if the stock rises to 70 (i.e. you expect volatility to increase).

Here are your call option choices:

Sept 08
55 - $6.20
60 - $3.50
65 - $1.35
70 - $0.50

Dec 08
55 - $8.30
60 - $6.48
65 - $4.10
70 - $2.10

It seems to me that it would be difficult to capitalize on the increased volatility resulting in increased time value with the September calls, due to decay.

It also seems that the time value of the current in-the-money calls becomes suppressed as they become deeper in the money (assuming the stock climbs as expected).

So, what's the best way to capitalize on both the stock price increase AND the volatility increase? December out-of-the money calls?

I know this question is probably a lot more complicated than I am making sound like. Many thanks in advance for your help.

Your prices dont really make sense, with the 55 call at 620 and the 60 call at 350, the 55 call is a much much much much better deal........ so buy infinite 55 calls.

edit: either month for the 55 calls

How can you tell? For example, assume the stock rises to $70 on 9/15, roughly a week before expiration. Your 55's are going to be worth $15 plus very little time value, and your 60s are going to be worth $10 plus very little time value. Let's assign 50 cents as time value.

So, one goes from 6.20 to 15.50, a gain of $9.30 or 150%. The other goes from 3.50 to 10.50, a gain of $7 and 200%. If you spent the same amount of money on each, you would have bought nearly twice as many 60s, which more than offsets the $9.30 to $7.00 profit spread.

Ok, well the 60 call is out of the money. So, the 3.50 is pure extrinsic value (time value). The 55 call is in the money, so it should have roughly 3.50 of time value plus parity. Parity for the 55 call is 4.50. The call costs 6.20. 6.20-4.50 = 1.70 which is much less than the 3.50 that the 60 call costs.

As for rising to $70 that is very situational. The fact is, most of the time a stock wont make a big move like that and the 55c will remain the more profitable solution.

By the way, if someone who is more knowledgeable than me could confirm or reject this that would be nice. Im not totally sure on this response.

so the deepest in-money options you can get are always optimal? hmmm...

Well obviously not. As you get deeper and deeper in the money and the delta closes in on 100, time till exp. becomes less and less of a factor and time value is reduced to almost nothing. I was just trying to make a point that these prices seem a little off.

I said that the 55c should have roughly 3.50 in time value as well since it is not a deep money option and should have a delta close to 50 (depending on various conditions etc.)

You should be able to google up excel spreadsheets with blackscholes models. Go from there.

There are software tools like Optionstation for analyzing stuff like this.

BTW, don't assume that just because the stock goes up that the implied volatility will also. The velocity of the move has more impact than the direction or size of the move.

It also depends what what is the cause of the increase in price. For example, if earnings are 8/12/08, and people have no idea whether they're going to meet expectations or exceed them or whatever, then vol will be jacked. However, once the event passes, the price might change a bunch, but vol will come back in.

ise.com

you can get volatility quotes. It's best to compare implied volatility to historical volatility. If its not in line with it you either buy or sell.

If the implied volatility is abnormally higher than historical volatility, you should sell

If the implied volatility is abnormally lower than historical volatility, you should buy

It sucks because it goes against human instinct. It's more fun to buy high implied volatility stocks but its completely -EV lol.

Google volatility smile.

sorry to hijack but I have a minor question and didn't want to start a thread, and this one seemed appropriate enough.

I was reading about delta hedging. The concept makes sense to me when you are talking about using the same underlier (e.g. long call + short stock). But I also saw the term used to describe an entire portfolio (i.e. the process of making the summed delta, of a series of unrelated investments, close to 0). How is this meaningful? What if you are long in stock X and short in stock Y, and stock X and Y tend to move in opposite directions. What use is it to say that you are delta neutral here?