#30 - When Is An Options Contract Expensive Or Cheap?
Hey everyone, Kirk here again and welcome back to the daily call. On today’s call, we’re going to talk about when is an options contract expensive or cheap. This is all relative. That’s the first thing you have to understand about being expensive or cheap. It’s all relativity. I use the real estate analogy all the time when it comes to option pricing. But let’s say a one bedroom apartment in New York, if I told you that that piece of real estate was priced at $25,000, you would say, “Holy crap! That is insanely cheap!” Because houses and apartments in New York are really expensive, so if you find one just randomly for $25,000, not that it would happen, but just to prove the point, you would say that that’s insanely cheap. Now, in my area where I live, in Pennsylvania, if you find a house for $25,000, it’s not necessarily cheap, but it’s not expensive either. It might be the middle of the road for some areas because we just live in a low cost blue collar area and that whole concept of being cheap or expensive is relative. Now, when it comes to options trading, we can use implied volatility to give us a sense of whether options are cheap or expensive. Generally, when implied volatility is high… You can figure out what implied volatility is and get charts of it on most broker platforms. But when implied volatility is high, then option prices are generally expensive. The reason that they’re expensive is because the market is expecting a big move in either direction or market participants are expecting a big move in either direction, so they bid up the value of options on both side to compensate for this potential higher move. Now, on the other hand, when implied volatility is really low and market participants are not expecting the market to have big swings in either direction, then option pricing is seen to be relatively cheap. You don’t have to pay a lot of money, but you also might not get the big moves in the underlying stock that you expect. What people often do is they often buy options during periods of low implied volatility, assuming that the market is going to have this big breakout period, but the problem is we just don’t know when that breakout period is going to happen. When is the market going to have these huge moves and huge run-ups in premium and prices or huge rundowns? We don’t know. Is it going to be two months out, three months out, four months out? Right now at the time that we’re recording this podcast is a great example of this because we’ve gone through now years of generally low volatility and many people have probably lost a lot of money buying options, assuming the next crash is right around the corner, but then it’s not and then they buy options, assuming it’s next month or it’s the month after. You can see how this thought process could lead people to losing a lot of money buying options. The end result here is that on some level, option premiums are always a little bit expensive and they are always overpriced by some margin long-term. Does that mean that buying options doesn’t work? No. In some small cases here and there, buying options works. But if you’re going to be a consistent income trader, then selling options when they’re relatively expensive ends up being what you need to do. What we say and the way that we run our system because of all the back-testing and research that we’ve done, is that when implied volatility is low, that doesn’t mean that option selling doesn’t work. It still does. It still generates a positive expected return, but the edge is much smaller, meaning that the overpricing in options is much smaller when implied volatility is low. Does that mean we stop trading? No. It just means that we scale down or pull back our position size dramatically. We keep more cash available. We don’t invest in a lot of securities. We try to keep a very light and airy portfolio with just a few tickers here and there and a good mix and diversity. Now, when implied volatility expands and option pricing goes dramatically higher, we get a lot of volatility in the market, maybe a market crash, mini crash, correction, whatever you want to use as the catalyst for higher volatility, at that point, then we actually want to aggressively go into the market with bigger position sizes, end up holding more ticker symbols, a wider variety of ticker symbols. We want to do all of the things that become more aggressive towards selling options. That’s counterintuitive for most people because most people, when the markets are really crazy and volatile, they end up taking a step back and they end up pairing down. But without a doubt, what our research has shown is when the markets become more volatile, that is the opportunity to generate much higher returns, better win rates, better sharp ratios, everything, lower losses. It ends up being periods where you have smaller drawdowns with high implied volatility selling options. It’s absolutely when you want to get into the market just a little bit more. Again, to just wrap this up… When is an option contract expensive or cheap? You can basically use implied volatility as your gauge for relative cheapness or relative expensiveness of an option contract, but ultimately, all option contracts are overpriced by some margin because of implied volatility. As always, hope you guys enjoyed this. If you have any questions, let us know. Until next time, happy trading!
