Good Morning Scataphagos, Great question My answer: When I buy or sell an option contract(s), I do not care about the cost, I care about being making money on the trade. I never ever ever ever think about the cost of any trading, I always always always think about making money on the trade. Worrying about the cost of a trade is stupid, making money on the trade is smart.
I always look at it relative to something else like scenario, past, spreads ie. a call vertical 51/59 costing 3 is more "expensive" than a 50/60 costing 3.7
This is the reply I got from DeepSeek AI, which I find to be better than textbook definition. The AI first gives his reason and then replies to your question. REASON Okay, so I need to figure out how to determine if an options premium is cheap or not, and understand what fair value is in this context. Let me start by recalling what I know about options. Options give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) before a certain date (expiration). The premium is the price paid for this right. Now, the question is about whether this premium is "cheap" or "expensive." That probably relates to whether the premium is undervalued or overvalued compared to its theoretical fair value. Fair value, I think, refers to the theoretical price of an option calculated using a model, like the Black-Scholes model. This model takes into account various factors like the underlying asset's price, strike price, time to expiration, volatility, risk-free interest rate, and dividends. If the market premium is lower than the fair value, the option might be considered cheap, and if it's higher, expensive. But how exactly do you compute fair value? Let me think. The Black-Scholes formula requires inputs: current stock price (S), strike price (K), time to expiration (T), risk-free rate (r), volatility (σ), and dividends. The formula then calculates the call or put price. So if I can get all these inputs, plug them into the model, and compare the model's price to the market price, that would tell me if the option is cheap or expensive. However, volatility is a tricky part here. Because the Black-Scholes model uses implied volatility, which is derived from the market price of the option. Wait, that seems circular. If the market price determines implied volatility, then how can we use the model to determine fair value? Maybe the key is to use historical volatility instead of implied volatility. Or perhaps compare the implied volatility to historical volatility. If the implied volatility is higher than historical, the option might be overpriced, making the premium expensive, and vice versa. Alternatively, maybe traders use other models or methods to estimate what the volatility should be, thereby calculating a theoretical value. But I think the main approach is to use implied volatility. Wait, but if the implied volatility is derived from the market price, then it's not an independent variable. So perhaps the way to assess whether an option is cheap or expensive is by comparing its implied volatility to the historical volatility of the underlying asset. If the implied volatility is high relative to historical, the premium is expensive; if low, it's cheap. But I also remember that implied volatility is forward-looking and reflects the market's expectation of future volatility, while historical volatility is backward-looking. So maybe it's not just a direct comparison. Also, different time frames could affect this. For example, if the market expects an upcoming event that could increase volatility, the implied volatility might be higher than historical, but that doesn't necessarily mean the option is overpriced—it just reflects the expected future volatility. Another angle: the concept of "fair value" could relate to the cost of replicating the option through a dynamic hedging strategy, as per the Black-Scholes framework. If the market price is higher than the cost of replication, it's expensive; lower, it's cheap. But in practice, dynamic hedging is complex and requires continuous adjustments, so maybe this is more theoretical. Also, supply and demand factors can influence the premium. If there's high demand for options (e.g., as hedging instruments), premiums might be driven up beyond their theoretical value, making them expensive. Conversely, low demand could make them cheaper. So, to summarize my thoughts: determining if an option's premium is cheap or not involves comparing its market price to a calculated fair value, which is typically derived using a pricing model like Black-Scholes. The key input here is volatility. If the implied volatility (derived from the market price) is higher than the expected future volatility (perhaps estimated from historical data or other forecasts), the option might be considered expensive. Conversely, if implied volatility is lower, the option might be cheap. Additionally, other factors like the Greeks (Delta, Gamma, Theta, Vega) can provide insights. For instance, Vega measures sensitivity to volatility. If Vega is high, the option's price is more sensitive to changes in implied volatility. So, if Vega is high and implied volatility is elevated, the premium might be more expensive. Another point: comparing the option's current implied volatility to its own historical implied volatility. If the current IV is in the higher percentile compared to its past IV range, the option might be expensive relative to its own history. Also, the moneyness of the option (whether it's ITM, ATM, OTM) affects the premium. Deep OTM options might have low premiums but high implied volatility, which could be misleading. So context is important. In terms of practical steps, here's what I think: Use an options pricing model (Black-Scholes, binomial) to calculate the theoretical value of the option. Input the current parameters: stock price, strike, time to expiration, interest rates, dividends, and expected volatility. Compare the model's price to the market price. If market price < model price, the option is cheap; if higher, expensive. The challenge is determining the appropriate volatility input. If using historical volatility, compare to the implied volatility. If the implied volatility is higher than historical, the market expects more volatility, which could justify a higher premium, but if you disagree, you might consider the option expensive. But how do you know what volatility to use in the model? That's the crux. Because if you use the current implied volatility in the model, you'll just get the market price. So to have an independent estimate, you need a volatility forecast. This could be based on historical volatility, GARCH models, or other statistical methods. Alternatively, traders might use implied volatility from similar options or the VIX (for indices) as a benchmark. For example, if the VIX is at 15, but the stock's implied volatility is 30, and historically the stock's volatility is 25, maybe the option is expensive. But if the stock is in a sector expecting news, maybe 30 is justified. So, fair value is subjective based on one's volatility forecast. If your forecast of future volatility is higher than the implied volatility, then the option is cheap; if lower, it's expensive. In conclusion, determining if an option is cheap or expensive involves assessing whether the implied volatility (and thus the premium) is justified by your expectation of future volatility. Fair value is the theoretical price based on a model using expected inputs, and comparing market price to this gives the assessment. REPLY To determine if an options premium is "cheap" or "expensive," and to understand fair value, follow this structured approach: ### **1. Understanding Fair Value** - **Definition**: Fair value is the theoretical price of an option derived from a pricing model (e.g., Black-Scholes, Binomial). It reflects the "true" value based on inputs like: - **Underlying asset price** (S) - **Strike price** (K) - **Time to expiration** (T) - **Risk-free rate** (r) - **Expected volatility** (σ) - **Dividends** (if applicable). - **Key Insight**: Fair value is not static; it depends on assumptions about future volatility and other factors. The market price of an option may differ from this theoretical value due to supply/demand, market sentiment, or mispricing. --- ### **2. Is the Premium Cheap or Expensive?** Compare the **market premium** to the **fair value** by analyzing **implied volatility (IV)**: - **Implied Volatility (IV)**: Derived from the market price of the option, IV reflects the market’s expectation of future volatility. - **Historical Volatility (HV)**: Measures past price fluctuations of the underlying asset. #### **Steps to Evaluate**: 1. **Calculate Fair Value**: - Use a pricing model (e.g., Black-Scholes) with your estimate of future volatility (e.g., HV, GARCH forecast, or sector-specific expectations). - If the model’s output (fair value) > market price → Option is **cheap**. - If fair value < market price → Option is **expensive**. 2. **Compare IV to HV or Expected Volatility**: - If **IV > HV/expected volatility**: The market is pricing in higher uncertainty than historical trends suggest → Option may be **overpriced**. - If **IV < HV/expected volatility**: The market underestimates potential volatility → Option may be **underpriced**. 3. **Contextualize IV**: - Check IV percentiles/rankings (e.g., if IV is in the top 20% of its 1-year range, the option is relatively expensive). - Consider upcoming events (e.g., earnings, Fed meetings) that may justify elevated IV. --- ### **3. Practical Considerations** - **Moneyness**: ATM options are most sensitive to volatility. Deep OTM/ITM options may have skewed IV. - **Supply/Demand**: High demand for hedging can inflate premiums (e.g., during market crashes). - **Greeks**: - **Vega**: Measures sensitivity to IV. High Vega → Premium is more volatile to IV changes. - **Theta**: Accounts for time decay. A "cheap" option may still be unattractive if theta decay is rapid. --- ### **4. Example Workflow** 1. **For a Call Option**: - Current market premium: $5.00 - Black-Scholes fair value (using HV=25%): $4.50 → Market price > fair value → **Expensive**. - If IV is 30% vs. HV of 25%, and no catalysts justify higher volatility → Overpriced. 2. **For a Put Option**: - Market premium: $3.00 - Fair value (using GARCH forecast=35%): $3.50 → Market price < fair value → **Cheap**. --- ### **5. Conclusion** An option is **cheap** if its market price is below the fair value derived from your volatility forecast (IV < expected σ). It’s **expensive** if the reverse holds (IV > expected σ). Fair value is subjective and hinges on your volatility outlook, making it critical to align assumptions with market context and risk appetite. Tools like IV rank, HV comparisons, and pricing models help systematize this analysis.
A good start is smoothing the skew each expiration and also to make a forecast of all facets of the IV surface - short-term IV, long-term, slope, curvature, and earnings moves:
When I trade credit spreads I always calculate the premium collected as an overall percentage of the spread. Lets say I have a 10 point spread ($1,000.00) between my short and long options. If the premium collected is > $500.00 / 50% the options are "expensive", good for me because I'm selling. If the premium collected is < $500 / -50% the options are "cheap" not so good for me as the seller but maybe as a buyer. This way I get an IV and Greeks included estimate of "cheep" or "expensive" by comparing the option prices to themselves. I also prefer it when I collect more premium and improve the R/R.
Hello taowave, It does not matter if you think I am stupid or whatever that quotes means, all that matters is myself.
I think the OP is referring to value not absolute cost. a 10 pt spread ITM will cost more than a 10 pt spread far OTM. so always sell ITM spreads? cha-ching