Using the formula above:
Stock Price (AEX index in this case): 753.39
Implied Volatility (mid volatility, showed in the option chain): 13.86
Time until expiration: 42
Expected Move = 753.39 * 13.86/100 * square root of (42/365) = +/- 35.42
The Quick and Dirty Way: A simpler method involves looking at the price of an at-the-money (ATM) straddle
(a strategy that involves buying a call and a put with the same strike price and expiration date).
This method is less precise but can be calculated quickly and easily.
Using the quick calculation:
Expected Move = (13.30 (cost of ATM Call) + 16 (cost of ATM Put) ) = +/- 29.3
How to Use the Expected Move
The expected move can be used differently by investors and traders:
For Investors:
- The expected move can help investors assess whether their expectations align with the market's predictions. If in the example above you think the AEX will go above 850, you know that your expectations are a lot higher than what the market thinks (753 + 35 = 788). Are you too optimistic, or do you know something the market doesn't know? Are you right or is the market better at predicting? Only future will tell. But at least now you have an extra indicator.
- It can also be used to help set take profit or stop loss levels that are in line with market expectations. For example, if you are bullish on the AEX (in the coming 42 days) and you set a stop-loss at 740, you know that this stop-loss could easily be hit as the market anticipates a bigger move in that same time-frame.
- Comparing with previous expected moves of earlier timeframes, it can show whether or not the current timeframe will be more volatile/eventful.
For Traders:
- For options traders, the expected move can guide the selection of strike prices for a lot of strategies like vertical spreads, strangles, iron condors, and many more. For example, a very common way of determining the width of a short strangle is to sell the call and the put outside of the expected move range. In the example above you would set the strike of the call at >785 and the strike of the put <725.
- Another common use is to see what the market expectations are around important events, like earnings reports, or inflation numbers being published.
- Like investors, traders can also use the expected move to check if their expectations align with the market's.
Conclusion
Understanding the expected move of a stock can provide valuable insights into market expectations and potential price fluctuations. However, it's important to remember that the expected move is just that - an expectation. The actual price movement can sometimes be far off from the expected move, especially in volatile markets.
As with any tool, the expected move should be used in conjunction with other analysis methods and not relied upon in isolation.
