How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) – Part 2

Go back to Part 1.

How To Determine If IV is High or Low? (Cont’d)

Example:



Picture courtesy of: ivolatility.com

For AAPL, the IV figures (gold colored line) range between 24% to 54%.
The peaks / highs of the IV charts are around 45% - 55%. When the IV is relatively high for the stock, that means the option’s price is relatively expensive.
On the other hand, the bottoms / lows of the IV charts are about 25% - 30%. When the IV is relatively low for the stock, that means the option’s price is relatively cheap.
The area between 35% - 40% seems like the average area. Hence, when IV is around this area, the option’s price can be considered quite “reasonable”, not “expensive” or “cheap”.
Notice that when the IV is at the peak or at the bottom, it tends to move back towards its average area.

Implied Volatility (IV) & Options Strategy Consideration
When IV is relatively low (option is cheap) and is expected to rise, buy options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option buyer).
For example:
You expect the price to go up in the near term. Currently, the IV is also relatively low and it’s expected to increase, as it is approaching earnings announcement in a few weeks ahead. When you buy Call options, the option’s price could increase not only due to the rising stock price, but also as a result of the rising IV. Even when the price stays flat, the option’s price might still increase due to the increase in IV.
Buying Straddle or Strangle also can benefit from the rising IV.

When IV is relatively high (option is expensive) and is expected to drop, sell options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option seller).
For example:
When you’re bullish, you may want to consider a Bull Put Spread, which allow you to sell options (and collect premiums) with a limited risk.
On the other hand, when you’re bearish, you can consider a Bear Call Spread.

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

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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).

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Understanding Candlestick Formation – Part 4: DRAGONFLY DOJI & GRAVESTONE DOJI

The following are some form of Doji candlestick (Cont’d):
(Please refer back to Part 3 for the pictures of each of the following formation)

3) Dragonfly Doji
Dragonfly doji is formed when the Opening and Closing price are at the High of the session (i.e. Open = Close = High) and the Low price creates a long lower shadow, resulting in a candlestick with a long lower shadow and no upper shadow (Looks like a "T").
Dragonfly doji indicates that sellers dominated trading and pushed the price lower in the beginning of session. However, towards the end of the session, buyers reemerge and drove the price back to the opening level and the session high. This signals a potential trend reversal.

Dragonfly doji may imply a trend reversal depending on previous trend and future confirmation.

After a downtrend, or during a pullback within an uptrend, or when it’s formed at the support, the appearance of Dragonfly Doji could signal that a turning point is nearing (i.e. potential bullish reversal).
Because when the price has been in a declining mode for some time, the ability of the price actions to rally back to its highest level after the sell-off at the beginning of session shows some evidence that the bulls (buyers) might just have begun to step in again.
The following day needs to confirm its bullish reversal signal with a strong bullish day (e.g. a gap up or a long white candle on a high volume).

After an uptrend, or a bounce within a downtrend, or when it’s formed at the resistance, the appearance of Dragonfly Doji could signal that a turning point is nearing (i.e. potential bearish reversal).
For a Dragonfly Doji to appear, the price must first trade much lower than where it opened, and then it rises to close at its high point at the end of the day. The long lower shadow formed shows some indications that the selling pressures might have just begun. Although the bulls managed to regain control and drove the price back to its highest level at the close, the appearance of selling pressure suggests some signs of caution. The next trading day needs to confirm its bearish signal with a strong bearish candle (e.g. a gap down or a long black/red candle on a high volume).

4) Gravestone Doji
Gravestone doji is just the opposite of Dragonfly doji.
Gravestone doji is formed when the Opening and Closing price are at the Low of the session (i.e. Open = Close = Low) and the High price creates a long upper shadow, resulting in a candlestick with a long upper shadow and no lower shadow (Looks like an upside down "T").
Gravestone doji indicates that buyers dominated trading and pushed the price higher since the beginning of session. However, towards the end of the session, sellers resurfaced and drove the price back to the opening level and the session low. This signals a potential trend reversal.

Gravestone doji may imply a trend reversal depending on previous trend and future confirmation.

After a downtrend, or a pullback within an uptrend, or when it’s formed at the support, the appearance of Gravestone Doji could signal that a turning point is nearing (i.e. potential bullish reversal).
Because for a Gravestone Doji to form, the price must first trade much higher than where it opened, and then it drops to close at its low at the end of the day. The long upper shadow formed shows some indications that the buyers (bulls) might just have started to step in. Although the sellers (bears) managed to regain control and push the price back at its lowest level at the close, the appearance of buying pressure raises some concerns.
The next trading day needs to confirm its bullish reversal signal with a strong bullish day (e.g. a gap up or a long white candle on a high volume).

After an uptrend, or a bounce within a downtrend, or when it’s formed at the resistance, the appearance of Gravestone Doji could signal that a turning point is nearing (i.e. potential bearish reversal).
Because when the price is has been in a rally mode for some time, the ability of the price actions to drop back to the lowest point after the rally in the beginning of session demonstrates some indications that the sellers (bears) might have begun to step in again.
The following day needs to confirm its bearish reversal signal with a strong bearish day (e.g. a gap down or a long black/red candle on a high volume).

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