When is an option over or under priced?

The real answer to this question is that options are rarely, if ever, over or under priced. Today's options markets are very efficient and options tend to be "fairly priced" at all times.

The better question to ask is whether an option is relatively expensive or inexpensive. Just because an option is expensive does not mean that it is "over priced." There may be a very good reason why the option price has increased; e.g., an anticipated earnings release. There may also be very good reason why an option is relatively inexpensive; e.g., a planned take-over.

As the market becomes more concerned about future price movement, there is a willingness to pay more for options to protect equity positions or to take advantage of anticipated price movement. Once those concerns pass, option prices will likely fall to lower levels.

This whole discussion boils down to a study of implied volatility and how it can be used to assess current option prices. An option is only "cheap" or "under priced" if you expect implied volatility to increase. Conversely, an option is only "expensive" or "over priced" if you expect implied volatility to fall.

You can quickly determine the current implied volatility for any option through any decent options broker. Once you know what the current implied volatility is for an option, you can then compare it to where implied volatilities have been in the past. You can also compare current implied volatility to the historic volatility of the underlying security.

When comparing current implied volatility to where implied volatility has been in the past, you are looking at the changing market expectations for the future volatility of the underlying security. As IV rises, it reflects greater uncertainty and concern in the market for the future price movement of the underlying stock.

For example, you might see IV rise as a key earnings date approaches followed by a return to prior levels once the news breaks. That news may be the catalyst for a large price move, up or down, or it may unfold as a non-event despite the heightened uncertainty that preceded it.

A comparison of implied volatility to the historical volatility of the underlying security allows you to assess whether the market's expectations are consistent with what the stock or index has done in the past. As we have all read in any prospectus or financial disclaimer, past performance is not an indication of future results.

So, if you see IV rising or falling relative to historic volatility, it does not mean that the option is "over" or "under" priced. Rather, it should prompt you to question why the market is pricing in a greater or lesser amount of future volatility. Once you identify the catalyst for the IV change, you can then determine whether you want to be long or short vega.

There are several tools out there that can assist you in this analysis. The "right" tool is largely a function of personal preference. Your goal is to assess current implied volatility for purposes of determining whether you prefer being a net buyer or seller of options.

More information is available on our web site. You might consider reading the article entitled "Implied Volatility - Buying And Selling Stock Options" for further discussion about how IV can impact your trading decisions.

Christopher Smith
TheOptionClub.com