Stock Option Pricing
Betting on Implied Volatility With Stock Options
By Frank Kneipher
May 20, 2007 - 11:09:22 AM

Betting on Implied Volatility

Serious traders usually never buy options on low-priced stocks because the added leverage usually isn't worth the headache of managing an option position.

For two straight sessions, call options on Sun Microsystems' $5.33 a share stock has attracted explosive trading volume as some investors bet the implied volatility of the options will increase as the company spends $3 billion to buyback stock.

So far, these traders have been right -- and this may soon highlight an opportunity to sell overpriced Sun Microsystems call options. The technology company's options are priced in pennies which exacerbates options prices on a cheap stock.

When the stock price changes, options volatility increases by three to four points -- instead of normal one to two point volatility movements. This helps show why one trader recently bought 90,000 June 5 calls and 6.84 million shares of Sun Microsystems stock to form a "delta neutral" position that will increase in value if the options volatility increases.

The volatility is currently around 35% in Sun Microsystems, and could be a good sale at about 45%. Traders often sell options when their prices, as measured by volatility, become historically expensive.

All this may seem likely an overly technical explanation, but it is merited at a time when Sun Microsystems unusual trading volume will be used as justification of all sorts of rumors and speculation.

To be sure, business will not likely get much worse for the company, and it could get materially better. Kohlberg, Kravis & Roberts, a private equity firm, bought $700 million of Sun Microsystems' convertible senior notes earlier this year, which may some investors consider a sign that the $19 billion market capitalization company could be taken private.

Its been said that Sun Microsystems calls are still a cheap way to bet on a stock. The calls enable traders to spend one-tenth the price of the stock and still control the shares until July expiration.