Why The Expected Move Matters for Options Traders
In an era of unprecedented computerized trading, it’s estimated by JP Morgan that over 90% of all buy and sell transactions for any asset class (stocks, options, futures, etc.) are performed by computers operating autonomously via algorithms. So why does this matter for the typical trader of options?
Well, it matters because it suggests there might be other factors beyond speculation, hedging, and supply/demand that influence the price of an asset, and subsequently, the price of an asset’s options. Algorithms make decisions to buy or sell stocks and futures for periods of a few seconds, minutes, and even weeks based on many different and often secret determinants.
One technical factor that is taken into consideration for most algorithms, which is available to anyone who has the gumption to look, is known as “the expected move.”
What is The Expected Move?
At the core level, the expected move is the amount an underlying asset is expected to move either up or down in a given time period. The expected move is derived from the pricing of an asset’s options.
Magnitude and duration of the expected move can vary immensely depending on pending binary events and the historical volatility of the asset. Merely knowing what the expected move means, at the very least, levels the playing field between billion dollar HFT funds and mom-and-pop retail options traders.
How is The Expected Move Calculated?
Without getting too technical, the expected move of an asset is derived from the pricing and implied volatility of at-the-money options contracts for the underlying instrument. For example, if volatility is high for front-month options in SPX, the expected move will, in general, be large.
Conversely, if volatility is low in the options, then the expected move will be very small. If the market is not pricing in dramatic movement either up or down, investors don’t see the need to pay hefty premiums to protect their respective long or short positions.
What this means is, market makers and institutional participants who set the prices (and therefore set volatility) for these options know precisely what they’re doing. There’s simply too much money on the line for inefficiencies in the marketplace. Electronic market makers and algorithms determine the probabilistic range that a security will go up or down for the day, month and year; this is invaluable information for options traders.
How to use The Expected Move When Trading Options
Not only does the expected move provide options traders with the knowledge of how much the underlying asset should go up or down on a day-to-day basis, but perhaps more importantly, it provides an estimated range for several months or the entire year.
Savvy options traders use the expected move before employing any options trading strategies.
In this screenshot below of the thinkorswim trading platform by TD Ameritrade, the expected move of the S&P 500 for each expiration is circled in red on the righthand side.
For the July series options expiring in 21 days, the S&P 500 is expected to trade up or down $37.49 anytime before expiration.
The expected move is undeniably telling you how options are priced, but how you interpret the expected move and trade off of it is entirely up to you.
Trading Based on the Expected Move
If a trader is looking to profit from purchasing options, i.e., long call, long put, call debit spread, put debit spread, it might be wise to select strike prices within the expected move.
On the contrary, if a trader is looking to profit from selling option premium, i.e., short call, short put, iron condor, call credit spread, put credit spread, etc., it is a common strategy to sell options that are outside of the expected move due to the increased probability of these options expiring worthless.
However, the giant caveat with the expected move is that it is by no means a guarantee. For example, if a trader sells put options that are outside of the expected move, they demonstrably have an increased probability of expiring out-of-the-money and ending up worthless.
However, if an unexpected event occurs that sends the market lower, the short puts that were originally outside of the expected move are going to exponentially increase in value and leave the put seller in deep trouble.
The expected move raises questions of which form of options trading is the most profitable in the long-run: selling options or buying options? Ultimately, it’s up to you to determine how to trade options based on the expected move.
Conclusions an Options Trader Can Draw from The Expected Move
Although the expected move doesn’t provide a direction that an asset will trade, it’s not necessary. Here’s why: If you have a fundamental understanding of any particular market, like crude oil for example, you don’t need to know the direction, you only need to know the magnitude. And, arguably, knowing the magnitude is more important.
Say you’re bullish on crude oil. Imagine summer is coming, more people are going to be traveling, and oil stockpiles are forecasted to decline.
What do you do with this bullish crude oil thesis? Buy crude oil futures? Options traders would say not so fast…
You can easily create a long position via buying calls, but how do you know which calls to buy? If crude oil is only projected to move $2.00 in the coming month, it wouldn’t make sense to purchase calls that are more than $5.00 out-of-the-money, for example.
Essentially, the bottom line is this: the expected move matters because, as a trader, you need to ensure that you’re not off base with your own expectations of how much an asset is forecasted to move in a given period of time.
With all of this said, merely knowing what the expected is for any given day/week/month/year for any given asset is an extremely useful tool for any options trader to have in their repertoire. Knowing what to expect in the options market is the first step towards knowing how to take advantage of it.
