Spotting the Best Option Values
07/25/2011 4:08 pm EST
Geoffry Wong recommends that all option traders look at both puts and calls that are equal distances from the strike price in order to find the best option values.
If you’re an option trader, you know what an option chain looks like. It’s basically the menu of options that you can buy or sell. But how do you know which of those options offer the best value for you?
Our guest today is Geoff Wong, so Geoff, when I see an option chain, how do I know which is the best one for me to buy or sell, which strike price, which month? How do you do that?
Okay, Tim, in order to not get into the math, let’s just look at options as a probability-based program. Every option has a probability, and that probability is the actual Delta.
So if a particular strike price has a 40% Delta, that also is synonymous with expiration. The market is saying there’s a 40% chance of likelihood this will actually settle in the money.
So if we’re going to look at an option chain, and this is a question I get all the time: How do I know I’m buying value? Let’s look at Apple (AAPL). Apple is trading for $325 (at time of interview). A 330 call, which is $5 out of the money, versus a 320 put, which is also $5 out of the money, should have equal probability of exercise or equal Deltas.
Let’s say that Delta is 40% on each one. The premium also should be the same because if there’s equal probability that either one of these strikes can be executed, that means that the premium should trade exactly at the same level.
So when looking at an option chain, one must keep in mind that you have to look at something equidistant away from where a particular strike is trading and look for value. So if they’re both 40%, then they should both be trading at the same level.
See related: Read Option Chains Like a Pro
But everybody is going to see this of course, right? So it’s probably going to rebalance relatively quickly.
Very fast. Then there are times, Tim, that the marketplace has a bias to the downside.
Let’s say the 320 put now is trading at ten cents more than the 330 call, and that’s where the problem lies. How do we take advantage of this cheaper option that has the same probability of exercise.
This is where the Delta-neutral strategy comes into effect. You buy the cheaper option, go completely flat neutral (Delta neutral), and then take advantage of the operation by buying a cheaper option that has equal probability of exercise and rebalancing the Delta-neutral position. That’s the way I take advantage of it.
See video: Understanding Delta-Neutral Options
How sophisticated of an option trader do I need to be to do this?
This is actually more than 101 options, Tim, because now you’re adding a component of being Delta neutral, also looking for value and how to take advantage of the trade. So yeah, it’s a little bit of a step beyond just options 101.