Options: Low-Priced Doesn’t Mean Cheap

06/07/2011 3:00 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Option expert and author Dan Passarelli discusses why some low-priced options are not really cheap at all, and shares tips on how to determine if an option will give you an edge.

Newer option traders may want to find ways to get into this cheaply and not use a lot of capital to dedicate to learning options and how to trade options, but is a cheap option necessarily a good trade?

Our guest today is Dan Passarelli. He’s an expert in options. So Dan, talk about inexpensive option strategies I can use to get into this business.

Well, you know that’s kind of an almost trick question because there are so many factors that go into the value of an option.

Like I might look at a stock like General Electric (GE); it’s nominally inexpensive. And I might look at a stock like Google (GOOG), that’s nominally very high-priced.

The GE options, the at-the-money calls that have two months until expiration, they’re going to be trading for a lot smaller a value than the at-the-money, two-month options in Google just because of the value of the stock price because options are priced off percentages, so higher-priced stocks will have higher-priced options.

The more time to expiration there is, that comes into play, volatility comes into play, so it’s pretty darn tricky to just spot a cheap option. Just because an option is trading for $0.20 doesn’t necessarily mean it’s cheap; it might be expensive.

What are some clues that I can look for to find out if there’s value in that? If I buy it that there’s a better chance of it going up than a different month that I see in the option chain?

This is something that I talk with my students about all the time. What I talk about is getting edge.

Option trading has some similarities to gambling. It’s not gambling, although you could make a case for it— unfortunately, some traders kind of look at it that way—but if you stack the odds in your favor, you can actually kind of be the casino in this sort of gambling analogy of a business.

The best way to put the odds in your favor is to look at volatility, and if I’m taking a simple directional strategy like maybe buying a call—granted, I know if the market goes up I make money, and if it goes down I lose money—but what I care about as the casino player is making sure that even though I’m speculating on this directional move, I want to get a good deal on that.

So I want to buy value in terms of volatility, and then if I make money, great, I will make more than I should because I bought these cheaper options. And if I lose money, I lose less than I should because I paid less than I should have.

Now is there certain stock or sector that you’d recommend starting with that would maybe have options that aren’t quite as volatile? That I have some time to make some money in that I can really get my feet wet here?

Yeah. You know, let me start with the things to avoid. Things like Biotechs and these high-flyer pharmaceuticals that have one or two drugs in their portfolio. Stay away from those.

What I recommend is to start with something small—well, not necessarily small. Start with something simple that you know, maybe an ETF like the S&P 500 Index ETF (SPY); maybe just a stock that you have interest in, and kind of go from there.

Just start out analyzing the volatility on one stock and then it’s kind of easy to add another one to your wealth of knowledge.

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