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How Do I Get A Good “Deal” On A Stock Option?

Posted by Pete Stolcers on December 4, 2007

Option Trading Question

I have heard people say they got a 'good deal' on an option price or that an option is overpriced.... what constitutes what is a 'good deal' or what is overpriced?

Option Trading Answer

Great question!

Many traders associate a “good deal” with a winning trade, but that doesn’t necessarily have to be the case.  There is a difference between timing the stock and buying the option when it is “cheap”.

When you conduct your analysis and you buy a call option on a stock that has pulled back, you are getting a “good deal” on the stock.  You are leveraging a long position on an asset that you believe is undervalued.  This doesn’t mean that you bought the options “cheap”. The implied volatility of the options could have gone up as the stock declined.

Before you construct an option strategy, you have to evaluate the implied volatility of the options. Two distinct considerations will determine if you are getting a “good deal”. 

First, you need to compare the implied volatility of the options to the historic volatility of the stock. The implied volatility of the options will indicate the market’s expected trading range for the stock.  If the implied volatility is low relative to the stock’s historical price movement, you are getting a “good deal”. For example, let’s say that you can buy a three-month straddle (by a put and a call with the same strike price and the same expiration month) for eight dollars.  This means that the stock needs to move eight dollars in one direction or the other in order for you to make money.  If you look at a chart and the stock has a history of moving $12 in either direction during a three-month period, you are getting a “good deal”. Remember, this doesn’t mean that the stock will cooperate.

Conceivably, the market has forgotten how erratic this stock can be.  If you feel that it will breakout, you will be buying the options at a bargain.  Imagine a situation where the stock has fallen dramatically (30%) on a news event.  The uncertainty surrounding the stock will create a huge spike in the implied volatilities.  Once the stock settles down it is likely to form a base over many months.  These stocks can often trade in a tight trading range while the market waits for news.  As the trading range collapses, the implied volatility drops.  If you buy the options, you are getting a “good deal”. However, the stock could continue to flat-line and you could lose money on the trade.

On the flipside, let’s say that the stock dropped 30% and you saw this as a dramatic overreaction to a temporary news item.  As the implied volatilities spike, you could sell an out of the money put with the intention of buying the stock at a lower price.  In this case, you are also getting a “good deal”.  The options are relatively expensive compared to the stock’s historical trading pattern.  I would caution you on this particular strategy.  It is never a good idea to try and catch a falling knife.  Stocks that have sharp declines usually take time to establish a support level.

I mentioned that there are two considerations that will determine if you are getting a “good deal”.  The second one compares the current implied volatility to the historic implied volatility of the options. The implied volatility of the options can be charted just like the price of the underlying stock.  When you view the chart, you can see how the current implied volatility compares to the 1-year range.

In the example below, you can see that BAC was trading in a tight range. The options were pricing in a relatively narrow trading range. When the stock broke support, the options were still relatively cheap. If you purchased puts, you got a “good deal”. Notice how the implied volatility increased as the stock dropped. You made money on the puts because you were on the right side of the trade and you benefited by an increase in the implied volatility.

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If you are buying options when the implied volatility is near the low end of the range, you are getting a “good deal”.  However, the opposite is not necessarily true.  Selling the options when they are near the high end of the 52-week range may not be a “good deal”.  Let’s explore both.

When the stock has gone through a “quiet period”, the Market Makers lower their expectations for the stock’s future price movement.  They do so by lowering the implied volatility of the options. As a result, the options are relatively cheap and they represent a “good deal”.  When you buy an option, you have limited downside risk and unlimited upside potential.  You know that what you paid for the option is all that is at risk.  If you were correct and the stock plunges (you bought puts), you will do very well on the trade. In the prior example, you can saw how the implied volatility of the options was at the low end of the 52-week range.

Selling options that are trading near the high end of the 52-week implied volatility range is a dangerous proposition.  The price of the options did not arbitrarily increase.  The Market Makers know when news is about to be released.  Uncertainty translates into “expensive options”.  I have seen many covered call writing scans that search out high reward situations.  They simply look for high implied volatilities.  Do not trust these systems, they do not account for news events.

Many novice traders will buy a stock that they are unfamiliar with and sell an at the money call with high implied volatility.  They rationalize that the stock can drop 20% during the month and they will still breakeven.  On the upside, the stock can stay flat or rally and they will make a 20% return. Out of nowhere, the company announces that the FDA did not approve one of their drugs and the stock drops 50%.  What seemed like a “good deal” was not.  You need to account for material announcements.  Most people don’t realize that selling naked puts (using the same strike price as the covered call you would sell) is equivalent to covered call writing.  When you sell options naked, your downside risk is unlimited and your upside is capped by the premium you collected.

In the example below, you can see how the implied volatility for UTHR spiked even though the stock was relatively quiet. The stock was about to announce earnings and it is common for the company to disclose material events. In this case, they confirmed the efficacy of a drug that is in late stage trials. The Market Makers suspected as much and they “juiced” the options. In this case, the covered call strategy would have worked, but it was not an optimal trade. Why would you enter a position with limited upside and unlimited downside when it is surrounded by uncertainty? I have seen situations where these stocks free fall. Even buying the straddle only generated marginal returns since the options were expensive.

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Uncertainty translates into higher implied volatility.  The market is very efficient and it is difficult to find a “good deal”.  The Market Makers are very astute and they have research teams and complex computer programs to help them price options.

I was having dinner with two colleagues that I respect and a debate broke out between them.  One argued that you should only buy cheap options.  The other argued that expensive options were the only ones worth buying.  Both had valid points and both were correct. Spend the majority of your time researching the underlying stock.  I feel that it is easier to time your trade than it is to find a “good deal”.  With that in mind, you should know how the options are priced.  If they are relatively cheap, look for buying strategies.  If they are relatively expensive, look at selling spreads.

Option Trading Comments

  • On 03/15, Tony said:

    I’m enjoying your site and glad I found it.
    Thanks.
    My question is; when I’m trying to research an option I’m looking at buying, how do I find out what the volatility on it is?

  • On 03/17, Pete Stolcers said:

    You brokerage firm should have implied volatility calculations in their option chains (if they don’t, find a firm that specializes in options). That will tell you the current implied volatility. However, it won’t tell you the 52-week range. I am currently trying to get that data so that I can construct implied volatility charts on my site. That might take a month for me to program. Stay tuned.

  • On 07/31, Kevin Cook said:

    I know I don’t have 10 grand to start. But I do have some to invest. I know nothing about option trading, but I’m doing my background, and have not bought any stocks through a broker ever. I do have a stock that I have researched and that I believe is going to make a dramatic surge in the next year. Is this the right way to go? Should I just go see my local broker or can I do it online?

    Kevin Cook
    Weatherford, Texas

  • On 08/01, Pete Stolcers said:

    I would not suggest a broker, but I would suggest reading a few books before you take a position. Putting all of your eggs in one basket is not the way to go. If anything goes wrong, you are dead meat. Even the smartest analysts know that they can’t predict all of the possible events that could impact a stock. 

    Please read a few articles from my How To Start Trading Options category in the right margin of this blog.

    Good luck.

  • On 08/14, Wendy Grimm said:

    Glad I found your site and read the article you wrote for ACTIVE TRADER magazine. I was just about ready to spring for an expensive package from one of those sites that claims everyone can be a very successful trader. Those people ought to be hung from the nearest flagpole--- one of the “mentors” had the audacity to say that she didn’t need to teach and was just doing it because she wanted everyone to be rich. Hogwash!

  • On 08/15, Pete Stolcers said:

    There are plenty of snakeoil salesmen like this. Be very careful before opening your wallet. Most of what is taught can be read in a book for 1% of the cost. You’ll find that the same information has been recycled many times.

    If you feel like nmentioning the firm, go ahead. It might help other traders.

  • On 08/15, Wendy Grimm said:

    The name of the company is BETTER TRADES. In particular Darlene Nelson is VERY CONVINCING. I hope everyone pays attention here and doesn’t get suckered in.

  • On 08/18, Pete Stolcers said:

    I do know Darlene from her days as a Wade Cook instructor and I have to question anyone authoring a book that sponsors “pooside trading”.

    Ever met a professional trader at a cocktail party? There’s a good reason - it’s tough! It’s not because no one has ever thought about it and it is not because no one has ever tried.

    Trust me, being you own boss, spending more time with your kids, fast paced action and making lost of money are very powerful touchpoints for intrigued investors. Be careful and don’t trust anyone who charges a small fortune to teach you.

  • On 02/27, igor said:

    Hi Pete,

    I think that I picked the wrong stock for trading BIIB
    Initially I had an APR 50 Call. After some time stock started to decline and I bought an APR 45 PUT.

    Currently Im +$100 on my PUT and (-$470) on my Call which is (-$365) overall.
    Is there anything that I can do to reduce my loss?

    To sell my Put and hope that Call will increase in value?

    By the way I had a TEG position and Im one of the winners thanks for that!

    Thanks in advance.

  • On 02/28, Pete Stolcers said:

    I’m glad you were in the TEG trade. That was an awesome 700% in 4 days and it continued to fall after we got out.

    BIIB, sell the calls and maybe even buy a few more puts. All of the healthcare stocks are taking a beating (along with the market). It broke key horizontal support at $47, it is below the 20-Day MA and the volume is picking up on the decline. Don’t look to make money on the trade, just try to sell your puts to scratch the entire trade. If you can break even on a poor trade, that is a victory. You were long calls because you liked the stock, it doesn’t make sense to hate it now. Take advantage of the downward momentum and get out.

  • On 02/28, Igor said:

    Pete,
    thanks a lot for response.
    I felt the same way but my problem is that I always hope that situation will become better and eventually I will recover.
    I bought BIIB call because of a huge gap that was in the beginning of August and I thought that this gap will be filled shortly but it didn’t work out

  • On 04/01, Terry said:

    Value on Put Option normally goes up when the stock price falls.  RIMM came out with earnings news yesterday and their stock price felt 5%.  I would expect the value of $65 put April 17, 2010 to go up as well.  But no no not the case, it felt today from $.69 to $.27.  Can anyone tell me what cause this to happen?  or is this April fools joke (which I would not mine if it is).  Appreciate it for answering my question.

  • On 04/01, Pete Stolcers said:

    The option premium explodes before earnings or any other event (FDA approval). Would you want to be short options before an event? Probably not because there is uncertainty. Traders that are short demand getting paid for the risk and the options are expensive. Once the number is out, the premium contracts because the surprise is gone. When you buy options ahead of an event, you need a BIG move.

  • On 04/07, johnr said:

    Thanks for creating this site.1)Can I sell an early month(april) and buy a later month(may) calender spread.If not why? 2) Suppose i buy a credit spread for june and its april now,can someone ever buy my short position if the price hits it? Thanks

  • On 04/07, Pete Stolcers said:

    Yes. You can buy the longer term option and sell a shorter term option with the same strike price against it. If the stock goes in the money, you can be assigned. You need to watch the intrinsic value of the short option. If it is trading at a discount, you will be assigned. The best way to unwind assignment on a call position is to buy the stock (assignment will leave you short shares) and sell the longer term calls. You do not normally want to exercise the longer term calls because they will contain time premium and this process will let you capture it. Also, consider buying bakc the short option when it goes in the money.

  • On 04/15, THEONE INVESTOR said:

    Have questions about the technical trend of two stocks.
    1) Would you consider LYB May 40 Call options as a viable bullish strategy (to sell just before earnings for small profit).
    the IV for the calls is 28.7, while the volatility avg for the stock is 32. So is the option a good buy at 1.85-1.90 range (it went up as I type this due to a spike - but I am not sure if it is worth paying more)

    2) DUSA - if you look at the chart http://stockcharts.com/h-sc/ui?s=DUSA here, do you think it has a 45 degree climb or is it too steep/material event driven (it has a gap).

    Thanks for any input..I know it’s OPEX today so I am too skittish to trade though..Cant figure out IV well enough yet.

  • On 04/19, Pete Stolcers said:

    I don’t see enough momentum in LYB to justify buying calls. If this is a pre-earnings play, you better have good information. How has the stock performed ahead of earnings the last 4 qtrs? Has the stock exceeded estimates in any of the last 4 qtrs? What is the average EPS beat the last 4 qtrs? How did the stock perform after the number the last 4 qtrs? Why would traders want to buy this stock ahead of earnings? has the company raised guidance? Is it breaking out on volume? Is the market going to rally and provide a tailwind?

    If you don’t know the answers to these basic questions, you don’t have a trade.

    As for cheap volatility, you can’t compete with the pricing models of billion dollar institutions that are making markets. They have sophisticated models that adjust dynamically and teams of researchers. If you find reasons to take a position in an underlying stock, look at the IVs to determine if they are rich or cheap and structure a strategy accordingly. Don’t trade simply because you think you have identified mispricing. I assure you, the IV is right were it should be.

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