Sunday, April 26, 2009

MythBusters- Inexpensive Options are Cheap

Here's the second installment to our option myths series started last week.

Myth #2: Inexpensive Options are Cheap Options

Beginning option traders are often tempted to buy inexpensive options. The *inexpensiveness* of the options may be alluring these traders into thinking they are cheap, thus an obvious buy. The reality is just because they're inexpensive doesn’t mean they’re cheap.

For example, BAC is currently trading at $9.40 and the May 12.50 calls are trading at $.37. There’s no doubt that $.37 for an option is inexpensive… but is it cheap? Well, let's look at the facts. We have a mere 3 weeks to expiration and BAC would have to rise to $12.87 just for you to breakeven (assuming you hold to expiration). That’s a 37% move in a very short period of time. This suggests that the 12.50 calls are trading at a very high implied volatility (as an option trading for $.37 that far OTM with 3 weeks left would have to be). Under a lower vol scenario, those 12.50 calls could only be trading at $.05. So the bottom line is you can’t look at an options price to determine if it’s cheap. You have to take into account it's strike price, time to expiry, and current levels of Implied volatility.

The most inexpensive options you’re going to find are short term, out-of-the-money options. Statistically speaking they have the lowest probability (vs. longer term ATM or ITM options) of being worth anything at expiration. It’s priced inexpensive because it’s a low statistical bet. Thus, if you decide to buy it you better be sure the stock has the ability to reach the short strike price prior to expiration. Remember the options market is quite efficient so don’t think that you’re getting a steal of a deal if an option is cheapo.

In an intro to economics class I took in college I was introduced to a phrase that sheds some light on this scenario: “there’s no such thing as a free lunch”. Remember for everyone buying an option, there’s someone on the other side of the table selling it to them. Odds are if the option was such a great deal (read: too inexpensive), then option sellers would be asking more for them. So don’t be too quick to think that those selling these *inexpensive* options are idiots...

... you never know, the idiot may just be you.

On a completely unrelated note, there are still two people who e-mailed my mac account (which had an egregious error and deleted my e-mails) expressing interested in a free month of the trading labs (one of them was Juan something...). I lost those 2 e-mails, so if you could both send me another e-mail: I'll get you taken care of.


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