Wednesday, October 3, 2007

How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) – Part 1

As discussed before in the previous post, in options trading, Implied Volatility (IV) has a huge impact on an option’s price.
An option’s price can move up or down due to changes in IV, even though there is no change in the stock price.
Some times, for instance, we also find a stock price has gone up, however the Call option of the stock did not increase, but it decreased instead. This kind of case is not surprising if we understand the factors that affect an option’s price. The reason why this phenomenon happens is usually due to a drop in IV.

Therefore, before we buy or sell an option, it is important to check if an option is relatively cheap (underpriced) or expensive (overpriced).
An option is deemed cheap or expensive not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive.
On the other hand, when the IV is relatively low, the option is considered cheap.

How To Determine If IV is High or Low?
Often, we come across some articles which suggested the way to evaluate if an option is cheap (underpriced) or expensive (overpriced) is by comparing IV against HV at a particular point of time.
When IV is considerably higher than HV, it means an option is expensive. On the contrary, when IV is much lower than HV, an option is considered cheap.

However, the problem is that IV is hardly related to HV, because IV is a prediction of stock’s future fluctuation for the next 30 trading days, while HV is a measure of stock’s fluctuation over the past 30 trading days. IV usually takes into account news or the coming important events. When an important event is expected to happen in the next 30 days (e.g. earnings announcement, FDA approvals, etc.), Implied Volatility will be relatively high. However, this may not be reflected in the “what has happened” during the past 30 days. Therefore, actually we can’t really compare IV vs. HV figures at a particular point of time.

To determine if an option is cheap (underpriced) or expensive (overpriced), IV figure at a particular point of time should be compared against its past IV trend.
Typically, IV (and HV as well) will oscillate from a period of relatively low volatility to a period of relatively high volatility. When IV is relatively high or low, normally it will tend to move back towards its average value. This pattern can be used to assess the reasonableness of an option’s price.

We’ll discuss an example and how to advantage of IV movement in Part 2.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

Related Topics:
* Options Trading Basic – Part 2
* Option Greeks


Anonymous said...

If a stock has available options in the form of open interst and there were 0 volumes listed on both the call and put sides, does this imply a lack of liquidity? Or does the open interest let you feel comfortable that you will be able to exercise that option once your position has been reached or you just decide to get out?



Hi Anon,
Thanks for your comments.

I've discussed about how I determine option liquidity in the following post:
How To Determine Options Liquidity?

In addition, I never have intention to exercise my options. So, when I buy options to open a position, I'll always sell the options to close the position.
In trading options, I only use options as a leverage tool to take advantage of the expected price move.