How to tell an option is overvalue or not in TOS?

OddTrader · Sep 7, 2009

Quote from wayneL:

"Expensive" options right now may turn out to have been cheap in a month's time if volatility increases.

"Cheap" options right now may turn out to have been expensive in a months time if the underlying goes moribund.

The trader must have an idea of where volatility is going (in other words, guess) before deciding if the current IV is too high or low.

IV versus HV is a tool people can use in making those projections, and yes volatility *tends* to be mean reverting, but in no way a definitive measure.

Bear in mind that the current IV is the market's collective opinion of future actual volatility. To make a judgement that the price is mis-valued is betting against the entire market in those options.

There is noting wrong with that, so long as the risk is understood.

The clearest example of this is leading up to earnings and announcements:

IV may start ramping way up above HV if traders believe that the announcement will move the market significantly. However if the markets moves much more than expected, those options premiums will have turned out to have been cheap. Likewise, if the market moves much less than expected, those options were massively overpriced. It's a collective best guess based on available information and a bit of soothsaying.

Bet against it? Sure, but just like betting on direction, you can get it right or wrong. How much that affects you depends on the strategy you're using, magnitude of move and your actions in managing the position as things develop.
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+1

RainmanRam · Sep 7, 2009

Quote from MTE:

He was referring to the mispricing of a particular option relative to other options in the chain. Think put/call parity, box spread and jelly roll.
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got it. thanks.

wuming79 · Sep 7, 2009

Hi wayneL,

Could you illustrate on how trade with IV? Is it possible to use IV to our advantage before we create a long position or a spread position?

Or do you have any good website or book to read about how to trade with IV?

wayneL · Sep 8, 2009

Quote from wuming79:

Hi wayneL,

Could you illustrate on how trade with IV? Is it possible to use IV to our advantage before we create a long position or a spread position?

Or do you have any good website or book to read about how to trade with IV?
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Well there's a book in that answer right there. But there are already some good tomes out there.

Here's quite a few to consider http://www.amazon.com/s/ref=nb_ss?url=search-alias=aps&field-keywords=options+volatility&x=17&y=13

wuming79 · Sep 8, 2009

Quote from wayneL:

Well there's a book in that answer right there. But there are already some good tomes out there.

Here's quite a few to consider http://www.amazon.com/s/ref=nb_ss?url=search-alias=aps&field-keywords=options+volatility&x=17&y=13
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Do you mean Option Volatility & Pricing: Advanced Trading Strategies and Techniques by Sheldon Natenberg ?

Bben1006 · Sep 8, 2009

Can one overestimate undervalued options, or better yet, can one underestimate an overvalued option?

trefoil · Sep 8, 2009

Quote from total_keops:

...cheap or expensive is a fact. Overvalued is an opinion.
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I swear, that is the most perfect market sentiment I have ever seen. Freakin' poetry.