Buying Overpriced Stock Options? Here's How To Tell...

My goals for this blog are to educate, and to offer real world examples of how to profitably navigate the options markets.

One topic that I'd like to cover is how to tell if an option is overpriced or underpriced.

Did you even know that was a thing, or even know that options could be overvalued or undervalued?

Well, it's true, and you might be buying overpriced options (or selling underpriced ones).

So I'm here to make sure you buy (or sell) when the option prices are just right.

A newcomer to the options game might automatically assume that an option is cheap or expensive based purely on its actual dollar amount.

But did you know, that an option that costs $1 per contract might actually be more "expensive" than an option that costs $5 per contract?

Yep, that's because in the option's world, expensive or cheap isn't defined by its dollar amount. It's based on the "volatility" level.

Let me explain.

What Makes Up An Option's Price?

There are six core components that help give an option its value:

1. Price of the underlying stock

2. Strike price of the option contract

3. Days until expiration

4. Volatility

5. Interest rates

6. Dividends

The first four components are the most crucial, and provide the bulk of an option's value. We will not discuss interest rates & dividends because they are a non-factor.

So, the first three in the list are easily measurable and indentifiable. Only "volatility" is the wildcard.

No doubt, the concept of volatility can be confusing, as it's a tricky subject to grasp at first. I'm here to break it down for you and why it's so important to understand.

Volatility, as it applies to options trading, is a measure of how erratic (or not) a stock has been over some period in the past, and how erratic (or not) it's expected to be over some period in the future.

Once that erratic-ness has been measured and calculated, it can be added into the option pricing formula.

If you think about it, it's correct to assume that stocks that fluctuate in large ranges will have a higher volatility component than stocks that are very stable.

Each stock has its own volatility component, and by studying where on the scale it currently resides, can tell you whether its options contracts are cheap or expensive on an historical basis. This is also a great indicator of whether you're getting a bargain if you are an option buyer.

Where To Get Volatility Data

Without a doubt, one of the best places for options and volatility data is at ivolatility.com

To get an idea of a stock's volatility, look at the volatility charts like the ones shown below.

Aflac (AFL) 1-year volatility

Tesla (TSLA) 1-year volatility

The charts above are volatility charts, not stock price charts. They are completely different, and are comparing Tesla and Aflac.

As you can clearly see, Tesla is a more volatile stock on an absolute level - its numbers are larger. And, its volatility spans from a low of 31% to a high of 91%.

Aflac, on the other hand, has cheaper absolute numbers, and spans from 8% to 32%.

The blue and orange lines represent different measures of volatility, but both trend in the same direction for the most part.

So do the charts tell us that TSLA is more erratic than AFL, and hence, its options should be more expensive?

Not necessarily.

Yes, TSLA's stock price may fluctuate more compared to AFL, but the key is to compare the volatility highs and lows of each stock to itself, not against each other. That would be like comparing apples to oranges.

If you are an option buyer, your goal is to buy when volatility is cheap compared to its past.

At the moment, it looks as though AFL's options are right in the middle of its one-year volatility range while TSLA's options are a bit on the cheaper side.

The Proof Is In The Calculations

How do we really know that volatility levels can affect an option's price? Let's take a look.

Using an option calculator, you can compare scenarios by changing any of the inputs on the left-hand side.

For TSLA, the only input that was altered was its volatility component, which was changed from 31% to 91%. These levels represent high and low points from its volatility chart.

Clearly, almost tripling the volatility component practically tripled the price of the call option.

With the $100 option multiplier, the $242.50 strike call option would cost approximately $1,497 when volatility was cheap or $4,243 when volatility was expensive.

That's a huge difference! And note, none of the other inputs were changed.

Comparing that scenario with AFL's volatility levels of a low of 8% and a high of 32%, shows similar results.

By quadrupling the volatility component, the $52 strike call option practically quadrupled in value.

With the $100 option multiplier, the $52 strike call option would cost approximately $78 when volatility was cheap or $314 when volatility was expensive.

Although that's thousands of dollars less than what TSLA's options cost, it doesn't necessarily mean that TSLA's options are more expensive.

For instance, an investor could be buying TSLA options when its volatility is at its low of 31% and also buying AFL options when its volatility is at its high of 32%.

Although both options would be trading around the same volatility level, the prices are still dramatically different.

In the option's world, "cheap" or "expensive" refers to volatility levels, and it is stock specific. AFL's high volatility is TSLA's low, and an investor would still be smarter to buy TSLA's options than AFL's if they were looking at option-buying strategies.

In the end, when looking to buy (or sell) an option, always check the volatility levels - it can mean the difference between paying retail or paying wholesale.

I hope this post has been eye opening.

We cover all kinds of option strategies here. If you have something specific in mind, shoot us an email here.

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Until next time...

- Lee