Is That Option Cheap or Expensive?

Focus: OPTIONS

Jared Woodard explains how you can use a common but very reliable metric to measure the relative value of a given option trade.

Every option trade or investment is an instance of a more general schema, an “if, then” statement: “Because of q, I believe that p, so I will risk some money to make a profit if p is true.”

The proposition could be about anything: it could be about the value of a company, the yield of a crop, or the outcome of a football game. Every case in which you risk some capital in order to profit from a future event is composed of the two activities mentioned in that schema: the process of forming a belief, and the process of risking capital on the outcome of that belief.

Structuring a desirable trade and executing the trade in the marketplace is the second process. I have written about that second process before in the context of options: the idea is that options are an essential part of any investor’s tool kit, because they allow you to express much more complex views and to express them more precisely than can typically be done with stocks or futures alone.

Buying or shorting shares of stock lets you say “yes” or “no” about a company. Structuring a position with options lets you say things like, “Yes, but only to the following extent, and before this date, and only under the following conditions...”

A lot of the educational material published about options trading tends to focus on the execution side.