fbpx Expensive Options (05:18) | Option Strategist

Expensive Options (05:18)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 5, No. 18 on September 19, 1996.

The volatility that has been introduced into the overall market since February has made most options expensive, or seemingly expensive. This comes after one of the most prolonged periods of depressed volatility that we have seen since options started trading: from 1991 through 1995 options were consistently on the cheap side, except for a few brief periods. Consequently, the current crop of option prices seems very expensive — especially considering what traders had become accustomed to over the past few years. In reality, it is more likely that they are just priced at higher absolute levels than one is accustomed to seeing. In this article, we want to address some strategies and tactics for handling "expensive" options.

First, it should be pointed out that current option prices may be "in line" theoretically and statistically, but to the naked eye they seem very expensive. And, in the real world, they cost a lot of money. A buyer of such options always fears that implied volatility might return to its former, lower levels, leaving the option buyer with huge losses due mostly to a decrease in implied volatility — not necessarily due to an adverse price move.

On the other hand, a seller of options may be deluded into thinking that the sale of these "expensive" options is an easy way to make money. If, in fact, the options are merely high-priced to the naked eye, but are actually correctly priced statistically, the seller could find himself with a problem, due to incorrect analysis.

The way that we measure the expensiveness of options is to use implied volatility. In one sense, that is the volatility that one would have to plug into a mathematical model in order for the model's estimate of the theoretical value of the option to be the same as the real-world price of the option. In another sense, implied volatility is the option market's estimate of the future volatility of the underlying index, equity, or future.

The following example may help to illustrate the power of implied volatility:

Suppose OEX is trading at 650. The following table shows the theoretical value of at-the-money call options with varying time remaining. Each line in the table is a different implied volatility.

Implied Oct 650 Nov 650 Dec 650
20% 15 1/2 22 1/2 27
18% 14 20 1/4 24 1/4
16% 12 1/2 18 1/2 22
14% 11 16 19 1/2
12% 9 1/2 14 17

 

The figures in the above table demonstrate – rather dramatically — how important implied volatility is. Suppose, for example, that you buy the Nov 650 call with implied volatility near its current levels of 16% (highlighted in the above table). That call would cost you approximately $1850. Now suppose that — in very short order and with OEX remaining at the same levels — implied volatility returns to the levels seen during the 1991-1995 period, and the beginning of this year: 12%. At 12%, your call would only be worth 14 points, or $1400. That's a loss of nearly a quarter of your initial investment, even though no time has passed and OEX has not fallen in price!

The same problem exists with individual equity options, although the average trader — unless he specializes in just a few stocks — is probably not as aware of it. OEX is something that most traders keep an eye on, and as such is the vehicle through which traders have a feeling as to the expensiveness or cheapness of options.

So what's an option trader to do? Strategically, you might say "sell options if implieds are high". But that's not a realistic approach. First, the current real volatility of OEX justifies an implied volatility of 16%. Second, suppose that you like the market — or are following a trading system that has just issued a buy signal — so you want to buy calls. The other simple bullish alternative — selling puts — on OEX offers only limited profit potential for a bullish trader, and the collateral required to sell a put is rather onerous ($9750 for an at-the-money put).

The Bull Spread

A very attractive alternative is to use a bull spread as opposed to an outright purchase. When options are "expensive", you will often find that the bull spread offers a very attractive potential percentage return — one that would be hard for the outright call purchase to match unless the underlying made a huge move upward.

Continuing with the above example, suppose that the Nov 670 call is selling for 9 ($900). The bullish trader could buy the Nov 650 call for 18½ (see previous table) and sell the Nov 670 call for 9. This net investment of $950 could grow to a maximum of $2000 (the difference in the strikes) if OEX were above 670 at November expiration. That represents a potential maximum return of 110%.

For the outright purchase of the Nov 650 call to produce an equivalent return at November expiration, the call — purchased for 18½ — would have to be worth 39 at expiration. That means OEX would have to rise from 650 to 689 to produce that return. That move is nearly twice as much as is required for the bull spread to maximize profits (recall that OEX only need rise to 670 in that case).

The biggest problem with using the bull spread is that if the spread has too much time remaining, it will not widen out to its maximum profit potential unless the underlying rises quite a bit above the higher strike. For example, if OEX were to rise to 670 a month before November expiration, the Nov 650-670 bull spread would only be worth about 13 — well shy of the 20 point maximum price. The best way to counter this phenomenon is to use relatively short-term options. Had the trader used an October bull spread instead of a November bull spread, and had he also been correct in his projection that OEX would rise, the October spread would widen faster than the November spread. That's why we usually only use options with a few weeks of life in our spread recommendations.

In summary, when options are expensive, the option trader should seriously consider buying a bull spread instead of a long call outright (or buying a put spread instead of a long put outright — the logic is similar). The spread may be able to outperform the outright purchase with a much smaller move by the underlying instrument.

This article was originally published in The Option Strategist Newsletter Volume 5, No. 18 on September 19, 1996.  

The Option Strategist Newsletter $29 trial

Share this

Option Strategist
Blog Search

Trading or investing whether on margin or otherwise carries a high level of risk, and may not be suitable for all persons. Leverage can work against you as well as for you. Before deciding to trade or invest you should carefully consider your investment objectives, level of experience, and ability to tolerate risk. The possibility exists that you could sustain a loss of some or all of your initial investment or even more than your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results.
Visit the Disclosure & Policies page for full website disclosures.

-->