The Secret to Valuing Options
Unlike stock investing, options buyers have to take into account the greater influence of time and volatility. That’s why valuing options premiums can seem difficult. Fortunately, it isn’t as hard as you might think…
Let’s begin by dispelling the myth of undervalued options. There is no such thing as an undervalued option. All options are overvalued. That is the incentive for an option seller to take on unlimited risk for a limited return. My specialty is finding options for buyers who are the only ones to possess the opportunity for unlimited profit with an always known and strictly limited risk.
The premium of a stock option depends partly on its relation to the underlying stock. This is signified by the option’s strike price as related to the market price of the stock at the time of the option purchase. If the strike price of the option is equal to the current market price, the option is considered “at-the-money”.
A call with a strike price above the market price or a put with a strike price below the market value is considered “out-of-the-money”. It is out-of-the-money because it would be worthless if it expired today.
For example, if you buy a Widget Co. $40 call, but the current share price is $37, it is out of the money. If you buy a ComTech $115 put when the stock is at $117, it is also out of the money, because you would not exercise either option. After all, why would you want to pay $40 for a stock when you could get it in the open market for $37? Conversely, why would you sell a stock for $115 when people were willing to pay $117 for it?
You buy an out-of-the-money option because you believe that given your forecast for the price of the shares and the time you are guaranteed until expiration, the shares will move above $40—attain an intrinsic (real) value, a calculable worth, and become “in-the-money”. That’s when the call’s strike price is below the current market price or the put’s strike price is above the market price.
When the time until expiration is equal, in-the-money options have a higher premium than out-of-the- money options. But, if the market makes a strong enough move in your favor, out-of-the-money options may give you a greater percentage return. They also tend to deteriorate more slowly than in the-money options if the underlying stock moves adversely, depending on the time until expiration.
When figuring out your profit target, keep in mind the break-even price. That’s the price the underlying investment must reach for you to recoup your premium by the option’s expiration date. You calculate the distance to the break-even price using the option’s strike price, the price at which the option holder has the right to buy (if it’s a call) or sell (if it’s a put) 100 shares of the underlying instrument, and the price you paid for the option.
For example, you buy a Widget Co. March $85 call option for $5 (a premium of $500). In order to recoup your premium, the stock would have to go up $5 (above $85 a share), so the break-even price is $90 per share. Since you have the right to buy 100 shares of Widget Co. at $85 per share, a price of $90 would gain you $5 per share, or $500 ($5 times 100 shares). This equals the $500 premium you paid to buy the option. Any further increase in the stock price is profit, $100 for every dollar rise in the stock. If Widget shares rise to $100, prior to the third Friday in March, each $85-strike call will have $1,500 of value. If shares are at or below $85 on that same date, your option will expire worthless. That is your risk.
For a put, do the opposite. Divide the premium by 100 and subtract it from the strike price. Once you figure out the break-even point, it’s time to decide if the risks outweigh the potential rewards.
While the option buyer has an always known and strictly limited risk, you will be well-served to remember that the risk is still extremely high, as it should be for the opportunity to earn unlimited gains…it’s the full amount of your bet, but not one cent more. If anyone ever tries to tell you that you can earn a high return with low risk, zip your wallet!
One of the secrets to our success at Options Hotline is that I’ll only recommend an option if it has a reward-to-risk ratio of at least 2-to-1. I compare the cost of an option to the intrinsic value if the underlying shares reach my objective. If the market makes the move I was looking for, within my allotted time frame, and the option play would only break even, I wouldn’t describe that as a sensible speculation. But if the market makes its move and the option price would multiply, in a short time, with an always known and strictly limited risk, then your play takes on a much more sensible aspect. It becomes, as my father liked to say, “the only sensible way to speculate.”
Editor, Options Hotline