Cheap and Expensive Options

When looking to buy or sell single options, one must
look for value as with any purchase.

Two main gauges are used to value options: mathematical
pricing formulas (namely, the black scholes formula) and
implied volatility. Simpler methods of measuring options prices include
dividing an at the money option by the underlying price
getting a percentage. The higher the percentage, the more
overpriced the option is.

The most commonly used method to value options is the Black
Scholes Options Valuation formula developed in the seventies.
The valuation requires the following: Underlying Price, option strike price,
option premium, historical volatility, expiration date, interest rate, and dividend rate.
Based on these inputs, you can get a value for any option in an underlying's
chain. Next, you would compare the black scholes value to the actual
options premiums. The greater black scholes price is in relation to the
actual price, the more overpriced the option.

The second method used to value options is Implied volatility.
Implied volatility is the volatility in the black scholes equation if
you use the actual options price as the black scholes valuation.
Basically, you would enter in the actual options price into the
black scholes formula and algebraically solve for volatility.
The higher the implied volatility, the more overpriced the options are.

Buying the most underpriced options

You can find the cheapest options simply by selecting an underlying option and ranking
the options by: greatest discount.

In this example for Microsoft options quoted on Dec 6, 2000.. the cheapest option is the
Jan 2003 30 put trading with an asking price of 2.625 and a theoretical (black scholes) price of 13.
This option has a discount of 10.37.


Selling the most overpriced options.

You can sort the same options to find the most overpriced options to sell. The most expensive option would be the Jan 2001 50 call with a bid price of 9.625 and a theoretical (black scholes) price of 8.49 giving a premium of 1.14.

Using implied volatility to value options

In this example we sort by greatest implied volatility to find the most overpriced options to sell.
We find a dec 200 100 call with an implied volatility of 500% at the very right column below:


Finding the best single options to buy or sell can be a straightford process when you use a widely accepted valuation equation
such as Black Scholes.


Copyright 2000 Star Research, Inc.
All rights reserved, no reproduction or re-transmission of this document is permitted without express
permission from Star Research, Inc.