Overview Of Option-Implied Outlooks
Long-Term Horizon, Medium-Term Horizon, Portfolio Strategy, Quantitative models
Seeking Alpha Analyst Since 2006
Geoff has worked in quantitative finance for more than twenty years.
Before entering finance, Geoff was a research scientist for NASA. Geoff holds a PhD in Atmospheric Science from the University of Colorado - Boulder and a BS in Physics from Georgia Tech.
Neither Geoff Considine nor Quantext (Geoff's company) are investment advisors. Nothing in any commentary here on Seeking Alpha or elsewhere shall be regarded as advice.
Summary
- Options on a stock or index can be used to build an outlook.
- These outlooks represent the consensus opinion of the options market.
- This post provides an overview and additional reading.
It is possible to generate an outlook for a stock by analyzing the prices at which options on the stock are trading. The market prices of options provide information about traders’ consensus outlook on the probability of the price going above a certain level (call options) or below a certain level (put options) over some period of time (from today until the expiration date of the options). By aggregating market prices of call and put options with the same expiration date but different payouts (different strike prices), it is possible to employ a mathematical model to calculate the implied probability of all possible future returns. This strategy is well-established in institutional finance. For some background, see the Minneapolis Fed’s web pages on their implementation. For a review of the literature on how options prices are useful in generating outlooks in general and with examples using my version of this approach, see this presentation.
The price outlooks derived from options prices are probabilistic rather than a specific forecast of the future price. The options prices may indicate increased or decreased likelihood of gains or losses and this provides insight into the prevailing beliefs of those buying and selling options.
The option-implied probabilities of expected price returns are charted as a probability distribution.
Option-implied 10.5 month price return probabilities for an S&P500 ETF (SPY)
When I chart the option-implied probability distribution for future return, I rotate the negative side of the distribution about the vertical axis so that the relative probabilities of positive and negative returns are easier to see. The previous chart, displayed in this way, is shown below:
Option-implied price return probabilities with negative side of distribution overlaid on positive axis
In general, I expect to see a distribution like this one for a broad market index ETF. The returns have negative skewness. The highest probabilities are for positive price returns (the solid blue line is above the red dashed line for the highest-probability outcomes). There is, however, also an elevated risk of very large negative returns as compared to the probability of positive returns of the same magnitude (the red dashed line is above the solid blue line for returns greater than 27% in magnitude. There is a higher probability of a -40% return than for a +40% return.
When I analyze individual stocks, the shapes of the option-implied distributions are more variable. For stocks that are in the midst of big run-ups, with lots of enthusiasm as to their boundless potential, it is more common to see distributions with positive skewness. In these cases, the most probable outcomes are negative but there is a very long positive tail. There is a high probability of loss and a low probability of extremely large gains. For examples of this situation, see my February posts on Peleton and Teledoc.
Outlook for TDOC from February 25,2021 to January 21, 2022 (Source: my Seeking Alpha article)
When the positive skewness becomes very large, I sometimes refer to these are lottery ticket stocks. This is not a knock on the company, but simply speaks to the odds of the outcomes for those who are investing at the current price. There is a substantial literature on stocks that provide these types of odds. Also see this paper and this one. Here are two non-academic articles by Larry Swedroe on these types of stocks: article 1, article 2.
By contrast to high positive skewness individual stocks, here is a an outlook from mid February for United Health (UNH):
Outlook for UNH from February 18, 2021 to January 21, 2022 (Source: my Seeking Alpha article)
This option-implied outlook is almost perfectly symmetric for positive vs. negative returns (the solid blue line and the red dashed line are basically right on top of each other).
The annualized return calculated from the option-implied price return probability distributions is a form of implied volatility.
The option-implied price return outlooks are the consensus outlook of the traders who are buying and selling options. I like to compare the option-implied outlook to the consensus opinion of Wall Street analysts. In effect, these are the consensus outlooks of two different constituencies.
Analyst's Disclosure: I am/we are long SPY.
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