Learn to Spot Option Bargains

09/13/2011 3:30 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Option educator Dan Passarelli explains that implied volatility—not the underlying equity—is the key measure to watch when searching for attractively priced options.

As an option trader, you have a lot of choices about which options, which strike price, which month of expiration you should trade, and our guest is going to help us find good ones to trade, Dan Passarelli.

So Dan, how do you find calls that are undervalued that we can buy, or maybe puts that are overvalued that we can sell?

Yeah Tim, this can be kind of tricky because a lot of people just look at calls as instruments of substitution for the underlying. Instead of buying the stock, I’m going to buy the call. If the stock goes up, the call should go up. If the stock goes down, the call should go down.

However, there’s more to it than that. In really determining whether or not the call is overvalued or undervalued, what you actually need to look at is not where the underlying is, but where the implied volatility level of the options is.

See related: Option Volatility Made Easy

Do you look at that on an option chain? How do you know?

Most options-friendly brokers will have implied volatility in a column, so you would just go across, you’d see the bid, the offer, the net change, and ultimately, you’ll see implied volatility somewhere.

Now, it’s also helpful to look at it in an implied volatility chart and have that plotted with the historical volatility of the option and compare them.

When you’re looking for a cheap option—call or put—you want implied volatility to be in the lower range of the last six months, and you also want it to be below historical volatility. That makes for a cheap option, direction aside.

Now with puts or calls, when we’re looking for an expensive option, it’s just the opposite. We want implied volatility to be near the top half of the last six months’ range, and we want it to be above historical volatility.

Now how about strike price and expiration? Do we want in the money, out of the money, and what month do we determine once we have one of those that meets our criteria in terms of implied volatility?

Sure, as you know, there’s a whole lot of different options that we can choose from, and it kind of depends on what you’re trying to accomplish.

Interview Continues on Page 2

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If you’re looking for a really quick, three-day, pretty powerful move—maybe you’re speculating on an event and you’re able to buy cheap implied volatility, which you can’t always do, the best thing is to buy a 25- to 35-Delta option.

See related: Know Your Option “Greeks

That’s where you get the most bang for your buck if you get a big move up to and through that strike price. You make the most, and they’re inexpensive, so you’re risking the least.

If you’re looking for more of a slow, steady move, maybe a couple weeks to a month, and you think it might be a more steady incline, then we’re looking for a higher-Delta option, maybe a 70- to 80-Delta call.

I would imagine that if we’re looking for undervalued or overvalued options, we’re avoiding the news-driven stocks for that particular day because it would seem that implied volatility would pop on those. So we want something that’s not been in the spotlight for the last couple of days or even last couple of weeks.

Right, you know, the market is a formidable foe. They’re not going to make it easy for you.

You’ve got to anticipate implied volatility a little bit, and what makes implied volatility rise—and just to break it down a little bit, when I say implied volatility, what I’m really talking about is what I was talking about when we first started: how cheap or expensive the option is. And that comes from supply and demand.

You know, for people buying up options because of an event like we’re talking about. You don’t want to be the last guy to buy the options to hedge or speculate on an event. You want to be the first guy. You want to buy those cheap options before they get bid up.

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