In tonight’s grad call we discussed the valuation of options. When purchasing an option, all one sees is a price, but is that expensive, cheap, moderate? How do we know if we are overpaying?
As a basic rule of thumb, when purchasing a 90 day OTM option, one should pay approximately 10% of the stock value. That is to say, if we have a $60 stock, we can expect to pay about $6.00 for the option. If we get the option for cheaper, hoorah for us; but overpaying for the option can lead to significant and frustrating losses.Â
 While the above rule of thumb works in a glance, a more detailed understanding of the option value will lead to smarter option decisions. The part of option pricing that causes an option to become overvalued is implied volatility. Implied volatility is the premium option sellers require to take on the option risk. We can think of it as a fear premium.
As fear of stock or market changes creeps in, the implied volatility rises and the option premiums increase. As the fear dissipates, the option values can fall dramatically even without significant stock price movement. Savvy option traders purchase options when the implied volatility is low and sell as the implied volatility peaks.Â
We looked at the ‘Volatility View’ function at www.optionsxpress.com to determine if the implied volatilities on specific stocks were high or low relative to their 52-week ranges. As we noted, most stocks are very high meaning their option values are inflated.
In times like this, out of the money options are riskier due to the potential drop in implied volatility. Some potential ways to combat the high implied volatilities at times like this are to do the following.
1.     Trade stock
2.     Do covered calls
3.     Buy in the money options (subject to less implied volatility risk)
4.     Use option spreads requiring the purchase and sell of similar options.
By understanding the valuation on our options, better trading decisions can be made. I wish you great success in your trades!
Happy Trades,
Jeff Yaede
No comments yet.