CHAPTER
15

Fundamental Analysis

In This Chapter

• The basics of fundamental analysis
• Determining what drives the underlying asset
• Limitations of fundamental analysis
• Fundamental analysis and options trading

Fundamental analysis drives a lot of options trading. People take a position believing that something will happen to make their positions pay off. When the evidence backing that belief is strong, the less risky the position will be.

The process is a mixture of global macroeconomic economic analysis and an examination of those factors specific to a particular underlying asset. Someone looking at single-stock equities would track the factors affecting specific companies. A trader in options on agricultural commodities might look at weather trends, and a trader in volatility options would look at movements in the market as a whole.

An option’s intrinsic value is tied to the price of the underlying asset. It’s time value, or theta, is tied to the calendar, and volatility, or vega, is related to the changes of the underlying. Fundamental analysis can give you a sense of the accuracy of the underlying price’s relativity to its value. Also, this analysis can help you understand the factors that might cause the price to change. The greater the time value of an option, the more things can change, and fundamental analysis can give you a sense of whether those changes are likely to move your position into-the-money. It’s the next-best thing to clairvoyance.

Why Analysis Matters

Because an option’s value is derived from the value of something else, and because its value includes the effects of time and volatility, it’s easy to forget an option has a relationship to an underlying asset. But it most definitely does.

Here’s a common situation: a trader starts writing deep out-of-the-money puts in the equity market to generate income. The logic is that the market has an upward bias anyway, so the option isn’t terribly likely to be assigned.

And then, the option is in-the-money, and the trader is stuck with stock she does not want. She is now convinced options are a terrible idea.

In addition, a trader who looks only at the value of the underlying asset might completely overlook the role of volatility, which is huge! Many clues about the amount and sources of volatility can be found through fundamental research. For example, you might be able to discern how much a particular asset is exposed to different market factors. This can lead to greater profits or, at least, fewer unpleasant surprises.

Now, suppose our intrepid trader did research on different stocks and found some she liked as long-term investments but thought they were too expensive to buy now. She wrote deep out-of-the-money puts on the most volatile of them, because greater implied volatility means a higher premium. She collected the income, and then waited. One day, the entire stock market has a break, her options are assigned, and she now has shares of a stock she wants to own, which were acquired at a good price. And, she gets to keep the premium income received from writing the put in the first place. It’s a win-win!

Her speculative income strategy fits into her overall investing program. Her research let her use the options market to improve her investment returns.

This is a simple example of how understanding the value of the underlying asset and the amount of volatility it is expected to have can help a trader use options to improve investing. Spend some time learning about how the underlying asset moves before diving into a new market.

Starting with the Macroeconomy

Options are economic assets. Every option is driven by the supply and demand for something in the economy. Even options on something esoteric, such as those on volatility measures, are based on economic factors. In the case of the VIX, which is the CBOE’s measure of the expected 30-day volatility of the S&P 500, the supply and demand for options is a function of expectations about the future economy.

Many options traders take a top-down approach and look at the economy of the world as a whole. They are looking for information about growth and volatility as an indicator of how the prices of specific underlying assets might respond to the what’s happening in the world.

A general understanding of the state of the world can be gleaned from the regular reading of such major financial publications as The Wall Street Journal and The Economist. They cover the world’s financial markets and look at factors of special interest to investors.

Economic analysts, whose work feeds into the stories you’ll see in the financial press, look at the government data. It’s easy to find if you want to crunch the numbers or digest the reports yourself.

Did You Know?

As a general rule, the world’s economy and markets are growing. We have more people and more money than ever before. Because of this, most markets will have an upward bias over the long term, but that doesn’t mean prices will increase at any particular time. A key part of your research will be looking for reasons why a given underlying asset won’t increase in price at the expected pace during your trading period.

U.S. Data Sources

The United States government releases an incredible amount of information about the nation’s economy. The main repository can be found at data.gov, which connects you to the different U.S. government agencies that collect data. Here, you can find such information as consumer price indexes, food price outlooks, and international trade data.

Some of the data sources are easier to reach by going through the agency’s website directly. The Census Department, census.gov, is a great resource for data about the economy, as is the Bureau of Labor Statistics (bls.gov) and, for commodity markets, the U.S. Department of Agriculture (usda.gov).

For information about interest rates, monetary activity, and the economy as a whole, check out the website for the Board of Governors of the Federal Reserve, federalreserve.gov. Here you’ll find definitive information about U.S. interest rates, including expectations for opportunity cost and inflation.

Global Data Sources

The World Bank (data.worldbank.org) collects global economic data, and is a good source of information about trends around the world. The Organization for Economic Cooperation and Development (data.oecd.org) is a consortium of the world’s most economically developed nations, and it tracks an impressive amount of data from member nations as well as other nations.

Of course, the numbers are only as good as the information submitted. Some nations are better at accurate reporting than others.

For economic information about the European Union, the site to see is the European Central Bank, ecb.europa.eu. For Japan, the Bank of Japan’s English-language site is boj.or.jp/en. In general, a nation’s central bank collects fundamental information about the country’s economy. You might not always find what you want in English, though. (Google Translate is useful in these situations to get you to the numbers. The numbers themselves are a universal language.)

Market Maxim

The major financial newspapers, such as The Wall Street Journal and the Financial Times, publish major data releases and analysis. For most traders, staying up to date with the news is enough.

Most of these sources are free. Some require registration; some are quite pricey but might be available at your library. And if you’re active in an area, it is not only worth your while to pay for research, but also might it be deductible from taxes. Nice, huh?

Single-Stock Options

Single-stock options are based on the value of the underlying stock. Companies are required to submit financial information to the U.S. Securities and Exchange Commission, and many companies release much of other information about their businesses to investors. Although many option traders aren’t investors, they will want to look at the same information used by the investor. Meanwhile, many investors use options to augment or protect an equity position or hold LEAPS or other long-term contracts as a stock replacement.

The primary driver of stock price performance is the expected growth rate in earnings per share. Even factors that look like they are not related, such as product announcements or merger activity, ultimately affect earnings per share. After all, earnings are affected by sales growth, investments in products and marketing, and good cost control. They are the source of funds to grow the company and to generate returns for investors.

Investment banks have analysts whose job it is to estimate earnings per share, and they report their numbers to different data service providers. The information is then aggregated and presented by almost all stock quote providers, including such free services as finance.yahoo.com.

The following table offers an example.

Earnings Estimates for Idiot Industries

When you look at analyst estimates, you’re looking for two things: the projected growth rate and the range of estimates. In the preceding example, the earnings estimate for the current year is 4.19, right there on the first line. On the last line, we can see the company had earnings of 3.70 for the prior year. That indicates a growth rate of (4.70 – 3.70) ÷ 3.70 = 13.24 percent. The range between the high and the low is (4.38 – 4.00) ÷ 4.00 = 9.5 percent.

If the estimates are in a tight range, then there’s less expected volatility. The implied volatility of the option is likely to be small, and the option is likely to increase in value if there’s a news event that changes the amount of volatility. If the range of earnings is wide, then the amount of expected volatility is probably large.

Along with the general business and financial news, one great source of unbiased research on companies and exchange-traded funds is Morningstar, morningstar.com. Some of their research is free, and the rest is priced to be accessible to individual investors.

Financial Products

The research on financial products will be similar to top-down research on the economy as a whole, because in essence, that’s what you’re doing when you’re looking at options on market indexes, interest rates, and currencies.

These factors influence the value of these underlying assets. They also influence the value of all options. That’s one of the reasons they have proven to be so popular.

A key place to go for information on financial assets is the Federal Reserve Bank’s website, federalreserve.gov. Indexes of different economic indicators are prepared by The Conference Board, conference-board.org, and the official arbiter of recessions is the National Bureau of Economic Research, nber.org.

Commodities

Most listed options are for single stocks or financial products, but they are hardly the only ones out there. Depending on your interests and your needs, you might want to look at options on commodities and options on commodities futures. There is a huge range of these derivatives! There also is a huge range of research sources specific to these different markets. Here are a few to check out:

Agricultural products:

• Department of Agriculture Economic Research Service, ers.usda.gov
• World Agriculture Supply and Demand Estimates, usda.gov/oce/commodity/wasde
• Food and Agriculture Organization of the United Nations, fao.org/statistics/en
• American Soybean Association, soygrowers.com
• National Association of Wheat Growers, wheatworld.org
• National Corn Growers Association, ncga.com

Energy commodities:

• The American Petroleum Institute, api.org
• The U.S. Department of Energy, energy.gov/data/open-energy-data
• The International Energy Agency, iea.org
• Energy Intelligence, energyintel.com
• Platts, platts.com

Metals:

• The U.S. Geological Survey: minerals.usgs.gov
• American Metals Market, amm.com
• World Bureau of Metal Statistics, world-bureau.com
• Platts, platts.com

Did You Know?

You might hear of market events referred to as black swans. This term emerged from work by a statistician, Nassim Nicholas Taleb. It refers to a random, unexpected event causing you to reassess your position. The idea is that if you live near a pond where white swans live, you might assume that all of the swans everywhere are white. If, one day, you see a black swan, your assumptions are challenged. At least one swan somewhere is black, and it’s possible that the all swans out there are black except for the white ones in your local pond. A lot of fundamental research is involved when trying to determine if an event is a one-off occurrence or a sign of more to come.

Looking at the Calendar

It’s obvious, and it’s also easy to forget: the time value, also known as theta, is an enormous component of an option’s value. The only indicator for it is the number of days left until the option expires. The longer the time to expiration, the greater the time value, because it’s more likely some event will occur to bring the option into-the-money. After all, tomorrow will probably be a lot like today, but nine months from now, the world will have new people who do not exist at this moment. (The metaphysics of time is really interesting and freaky stuff. And it applies to options trading!)

Time value is a simple concept that has a huge effect on the price of an option. A very long-term option, such as a LEAP, has its value based almost entirely on time. The time value of a weekly option has very little effect on its price. Everything else is in between. Most brokerage firms publish the time value of an option at a given point in time.

But, like sands through an hourglass, the time value of an option decline as the expiration date draws near. At expiration, it is worth nothing. The writer keeps the premium; the buyer is stuck. The exact rate of decay is the theta, and it varies in part by how much the option is in-the-money or out-of-the-money. There’s one binary choice: at expiration, the option will be worth exercising or it won’t.

If an option isn’t at or near the money a week before expiration, it probably won’t be on expiration day. And if it’s way out-of-the-money on the day before expiration, it probably won’t cross over. If the market is really volatile, it could cross over, but remember miracles are few and far between anywhere in the market. It could happen, but it might not.

If you are long an option, you have to decide whether it is better to cut losses by selling an out-of-the money option as it approaches expiration, or to hold on hoping it moves in-the-money instead of expiring worthless. (Hint: it’s almost always better to cut your losses and close the position.)

This effect is sometimes known as the option’s death spiral: in the days before expiration, the time value of an option declines to 0, and the price of the option falls along with it. The further out-of-the-money the option is, the greater the speed of the price decline.

Did You Know?

On the very first episode of The Simpsons, Bart Simpson said, “If TV has taught me anything, it’s that miracles always happen to poor kids at Christmas.” Miracles make for great TV, but they don’t happen often in real life. Could a miracle happen the day before expiration to make bring your out-of-the-money option into major profitability? Sure, it could happen. Will it? Probably not.

Fundamental Analysis in Options Trading

Options valuation is covered back in Chapter 5. There are a few primary factors involved:

• The price of the underlying asset
• The delta, or how much the option’s price will change as the underlying’s price changes
• The volatility of the underlying asset
• The time value of the option

Other factors, such as gamma (the rate of the rate of change of the price), figure in, but they can’t be evaluated without evaluating the basics.

The longer the time to expiration, the more important the time value is to the option price. For an option with a short expiration, the price of the underlying asset is the most important factor.

This is an important point to remember when doing fundamental analysis. Your visibility is limited. That’s why there are options in the first place! You can ensure against a different outcome, or you can speculate on it. The key issue over the long run is the amount of volatility. If you understand the issues that make prices change, rather than drive the direction of the change, you’ll be ahead of the game.

Although volatility is the often-overlooked component of valuation, the intrinsic value of the option can’t be ignored. This is especially true if you’re writing short puts settled with the underlying asset and could end up owning it upon assignment.

Naked-short puts on single stocks are risky for this very reason. Likewise, naked-short calls are risky because the underlying asset could have an infinite increase in price—at least in theory—and the writer will have to buy it at the high price if the option is assigned.

If you don’t pay attention to the stocks in question, you might end up with a stock you don’t want, which continues to fall in price. If you limit your writing to stocks you might want to own, you will be less likely to be suckered. In fact, if you structure your trades so you must buy only the things you are willing to buy, and sell only the things you are willing to sell, you will avoid many of the heartaches of option trading. (Of course, you might avoid some profits, too. It’s all a balance between risk and return.)

In theory, markets are perfectly efficient, so fundamental analysis is wasted. In practice, fundamental analysis is a great way to understand your risks and make the markets more efficient. If you don’t understand why the market value is what it is, all the efficiency in the world won’t protect you from doing something stupid.

Market Maxim

The stock doesn’t know you own it. Sometimes, we can get so caught up in a position we forget the stock owes us nothing. Options, futures, stocks, and bonds are things with no emotion and no loyalty.

Putting It All Together

Here’s a summary of the role of fundamental analysis in options trading:

• The value of an option can be broken down into intrinsic value plus extrinsic value, also known as time value.
• Intrinsic value is the value of the option relative to the value of the underlying asset when the option is in-the-money.
• An out-of-the-money option has no intrinsic value.
• Time value is a function of both the volatility of the underlying and the amount time until the option expires.
• Fundamental analysis can be used to get more insight on both intrinsic value (for example, by helping the trader understand the potential for price appreciation for the underlying asset) and volatility.
• Time value is the amount of remaining valuation. Is it reasonable?

The following table shows how fundamental factors can help in understanding the Greeks.

Fundamental Analysis and Option Pricing