A little common sense re when people would or should be buying options also helps. Two examples: 1 - This morning. As of yesterday IV generally went up because of the anticipation of Bernanke's speech today. Once he was done, it deflated rapidly. Selling options yesterday would have been a reasonable strategy. 2 - Earnings are coming up, and assuming you have familiarized yourself with the usual IV of the options of the company in question, you can make something buying options prior to earnings if the IV hasn't moved much higher, since usually there will be some significant move once earnings are announced, or selling if the IV shoots up prior to the announcement (as long as you don't sell naked). The only real homerun I ever scored was buying a strangle about a week before Lehman was going to announce earnings because I noticed the IV hadn't done anything - this was in March of '08, when Bear was already in trouble but before they went belly up. Because of the Bear Stearns weekend I made way more money on that one trade than I ever have on any other. Watch that IV.
What truly determines if an option in a security is over/under priced is where present IV/HV is relative to each other and also relative to their respective ranges. In simple terms-- here are two ideal scenarios: Buy when options are both "cheap" (historical volatility of the underlying is near the low end of its range) and "undervalued" (implied volatility is on low end of its range and also less than historical volatility). Sell when options are both "expensive" (historical volatility of the underlying is near the high end of its range) and "overvalued" (implied volatility is high and also greater than historical volatility).
I think there's a difference b/t undervalued options and mispriced options. At times, I'm not sure which one people are referring to.
This is sort of an unrelated question: How can I calculate the probability of a stock being outside a certain at a certain time? Also, how can I calculate the probability that a stock will trade outside a specific range in a given ammount of time, but not neccesarily close out of the range at the end of the time frame?
That stuff is all mumbo jumbo. No one knows the probability of anything, you can only view what they THINK the probability will be.
Actually, some of the probabilities are known perfectly well. Lets take a super-simple example - probability of s&p being below or above the Fridays close this coming Friday is 50/50. If you think that it's mumbo-jumbo and the price is different, give me a call, we'll trade. It's the fact that this is "risk neutral" probability that generally cooks people noodles. In any case, back to the topic of richness and cheapness. Overall, you should think of any option being rich or cheap based on the following: (a) is the current movement "implied" in the option too large or too small for this asset? There is a number of ways to do it, from simple break-even (stock has to move 50% for me to make money and it has never moved that much) to analyzing implied volatility with respect to your prediction of the realized volatility. (b) is this option too rich or too cheap with respect to the other options on this asset with the same expiry? Again, there are numerous ways of doing it, from (again) break even analysis - (if i buy this option and sell another one at a lower/higher strike in such way that i do not pay or receive premium, how likely am i to lose or make money?) to trying to understand how volatility changes with changes in the level of the underlying. (c) is this option too rich or too cheap with respect to other options on the same asset with a different expiry? Here, your analysis has to include (somehow) the response of the implied volatility to the changes in the world. E.g. if the stock moves 10% and I am long the option in the first month and short an option in the second, would your convexity in the front make enough money to pay for the richer volatility of the option in the back. Numerous ways to do it, usually you would want to use more then one. (d) is this option rich or cheap with respect to another option on a related asset? e.g. if you see an option on QQQQ, does it look rich or cheap with respect to the option (of the same maturity and moneyness) on SPY. Again, this could be as simple as a break-even analysis or as complex as understanding the relative risk premia of the two assets. The beauty of the options market is that it has a huge number of moving parts and there are always opportunities. The unfortunate (or fortunate, depends which side of the fence you are one) thing is that these opportunities (especially the ones that persist) are usually not large enough to be interesting. It is fairly easy to consistently make a 100% return in options on something like $100 or $200k (i could name a bunch of things i'd look at in this case). It's pretty damn hard to have a reliable 10% return on a $100mm.
That's why every time I get 100m I hire a 1000 options traders and give them each 100k. I tell them, "Hey guys all I want is 10%, so you can keep anything over 10k for the year."
I am flattered - you actually replied to every one of my comments from yesterday. That makes me feel special (or makes you a stalker). In any case, it is pretty hard to find even a single knowledgible trader that would be willing to work for 100k, less so a thousand ones. The key problem in capacity constrained strategies (e.g. 10 strategies x 10k/a) is that the amount of time spent developing and monitoring them is too large compared to the potential income. A simple example - looking at earnings vol for mid-cal and small-cap companies. Whilete there are usually dislocations, volume is insufficient to scale up past a relatively small private account.