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By: Costas Bocelli — May 29, 2010

How to Tell if an Option is Cheap or Expensive

Option prices are set by the natural pressure of supply and demand.  When deciding to take a position in an option, it will benefit you to know how expensive the option is on a relative scale: the volatility component of the price. 

The volatility of an option is how traders primarily assign the theoretical value.  Trading occurs because of the differing opinions on the market volatility of the contract.

Knowing this information will hopefully lead you to better decision making when trading options. 

The recent volatility in the market is elevated to say the least, so knowing the volatility levels of the contract is very important.

Let’s look at an example to illustrate relative pricing.

Family Dollar Stores (Sym: FDO), a discount retailer, is currently trading at $40.74 a share.

Discount Shoe Warehouse (Sym: DSW), also a discount retailer, is currently trading at $28.88 a share.

Which stock is more expensive?

Well, if you don’t know much about stock valuation, your answer would be FDO, as it is almost $12 more expensive than DSW.

But what if we look at the price to earnings ratio (P/E) of these two discount retailers?  The P/E is a valuation ratio of a company’s current share price compared to its per share earnings.

The current year forward earnings per share (EPS) in FDO is 2.57, and  so the P/E Ratio would be 15.85 (stock price/EPS).

The current year forward earnings per share (EPS) in DSW is 1.43, meaning its P/E Ratio would be 20.20.

You can see on a relative valuation scale, it appears that FDO, despite trading $12 higher than DSW, is the cheaper stock.  There is less of a premium commanded by the market for FDO than DSW based on future current year earnings.

Whether DSW deserves a higher premium than FDO in the market is for you to decide, but the point is that if you were looking at these two discount retailers, you have an idea on how they measure from a relative market valuation.

Another example to stress relative valuation:

You are in the market for a brand new automobile.  Which one would you buy?

The MSRP on a Mercedes S500 is $97,000.  The MSRP on a Toyota Camry is $26,000.

Nominally, the Mercedes is much more expensive, which may sway your decision to forgo the extra luxury for the more practical Camry.

However, if you can get the Mercedes dealer to sell you the S500 for $60,000 and you can get the Toyota dealer to sell you the Camry for $25,000 ...

Which one do you buy now?

Relative valuation implies that the Mercedes is a much better deal, and therefore, a cheaper price even though you are outlaying more nominal dollars.  You get better value buying the Benz.

This relative valuation has a direct correlation to the pricing of options.

An option's value is determined by 5 key variables.  4 of them are uniformly identified by options traders, especially with shorter term options: Stock price, Strike price, Time to expiry, and Carry Cost.

The fifth variable is Volatility.  Traders have different opinions on this variable because this value has to be forecasted based on future realized volatility that has not yet occurred.

The market sets the nominal value on option prices, so the model can compute the Implied Volatility of that option.  This implied volatility is the basis for determining how cheap or expensive an option is.

If you perceive implied volatility to be too high, then you are thinking it is expensive, and you may be prone to sell the option or avoid a purchase of that contract.

If you perceive the implied volatility to be too low, then you are thinking it is relatively cheap, and you may be prone to buy the option or avoid selling this low premium contract.

How do we know how relative implied volatility is?

As you know, an option has a correlation to the underlying asset, in this case, Stock.  The volatility of the stock can be measured and recorded.  We can look at the prior history of actual volatility of the stock, even in varying time frames.

On a general basis, when comparing historical volatility of the stock to the implied volatility of the option, you want to try and compare similar time frames.

For example, if you are looking at the implied volatility of a 30 day option, you may want to take a look at the historical volatility of the stock over the last 30 days.  If you are looking at a LEAP Option that expires one year from now, you may want to look at historical volatility on an annual basis.

Let’s look at two examples in the options market, one where we can identify a relatively cheap option and the other where we can identify an expensive one.

What a cheap option looks like in the market

Let’s say we look at an at-the-money option that expires close to 30 days from now, and it is trading around $4.15.  The implied volatility of the option is 38% (gold line).  From the below chart, we see that historical volatility in the past 30 days is around 49% (blue line).

What this tells us is the option's implied volatility suggests the option price is cheap relative to how volatile the stock has been moving around over the last 30 days.

Choosing to purchase or sell the option will ultimately be your decision, but as you can see, the odds are in your favor from the buy side.
 



What an expensive option looks like in the market

Let’s say we look at another at-the-money option that expires in 30 days, but in a different underlying stock where the option is trading around $3.25.  The implied volatility of the option is 17% (gold line).  From the chart below, we see that the historical volatility in the past 30 days is 10% (blue line).

What this tells us is that the option's implied volatility suggests the option price is expensive relative to how volatile the stock has been moving around over the last 30 days.

Again, you are responsible for your actions, but the odds are in your favor from the sell side.  The option premium appears rich relative to the volatility movement in the stock.

Going into an option trade, it will always benefit you to have as much information as possible.  Identifying the true relative value of an option should help you make better informed decisions when you want to use options to profit from your trading ideas.

By the way, if you hear of any Mercedes dealers unloading a brand new S500 for sixty grand, please leave me a comment.

Happy Memorial Day, please be safe and enjoy the holiday!

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