The Secret to Smart Options Buying

Steve McDonald (SM): Our guest this week is Karim Rahemtulla, The Oxford Club’s Options Strategist, and he’s here to talk about insider buying, open interest and volatility in the market – and how they relate to buying options.

Which one do you want to start with?

Karim Rahemtulla (KR): Well first, we’re not just buying options – sometimes we sell options too. And we’re always going to look for good companies.

So I want to talk about some technical indicators and things that I look for. For example, open interest tells me how liquid an option is, meaning how much it trades.

You don’t want to get into an option that has an open interest of, say, only 10 contracts – because that means nobody is trading it and you’re going to get a really bad price.

The other thing I look for is market volatility and options volatility. If the market is super volatile, that’s the wrong time to buy an option. But it’s the best time to sell an option – because you’ll take in more money when you sell but you’ll pay more when you buy.

SM: Let me interrupt you for a second – how does someone watching this know where to look for an indicator of market volatility?

KR: There are two places to look – one is the individual market volatility itself, and that’s the CBOE Volatility Index (VIX). That’s where you look on the market for an individual stock. You look at the beta of the stock, which measures the volatility of the stock versus the market.

If a stock has a really high beta, that means that when the market goes up, the stock goes up even more. A really low beta means that if the market goes up, the stock doesn’t go up as much. Those are a couple of indicators I like to look at.

The third one is more of a fundamental indicator, which is insider buying or insider selling.

Insider selling is not that big of a deal because people sell stocks for a variety of reasons – estate planning, paying for the kids’ education, whatever. But insider buying occurs for a particular reason. The person buying knows that something is going on at the company or will go on in the future. So that’s always been a very good indicator for me…

SM: Now, with the open interest, when you said they need to be liquid, what do you consider a liquid number?

KR: You have to have open interest in the hundreds or the thousands. Also, when you look at the bid and offer – meaning what you’re going to pay for the option or what you’re going to sell it for – it has to be a big number on each side. That number has to be in the hundreds or thousands as well.

If you see an option that’s trading with five contracts on the bid by seven contracts on the offer, that’s really not indicative of a very liquid option that you can get in or out of easily.

SM: Where can you direct our viewers to look for that type of information? How can you bring that up?

KR: On your options screen, when you’re trading an option, you will see these things. You can pull up an options chain, which is a chain of actual strike prices. Right next to the strike prices, when you click on “buy” or “sell,” it’ll have a bid and offer – a number on each side – and you’ll see an open interest there as well.

SM: Now, give us a number for the beta and the VIX. What do you consider volatile enough to trade?

KR: On the VIX, any time you approach 10 or 11 is considered a very complacent market. That’s a really good time to buy options because the premium is really low.

When the VIX is at 30 or 40, that’s indicative of a very volatile market. And that’s a good time to sell options because the amount of risk premium will be substantially higher.

As for a stock’s beta, it really depends on the sector. But a stock with a beta of 0.3 is considered fairly average.

SM: Well that’s fantastic. Karim, I honestly feel like I’ve just had a crash course on volatility and open interest. You know I don’t trade options, so I really appreciate your taking the time to be with us today.

KR: Any time, Steve.

— Steve McDonald

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Source: Investment U