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Lesson in Course: Derivatives and options (advanced, 5min )
When deciding to buy an option, how do I make sense of the current cost?
Everyone loves a good discount. But at what point does a discount become suspicious?
When we start looking at option chains, we'll notice that prices vary between deep-in-the-money options and out-of-the-money options for the same stock. We'll also see prices differ significantly between options contracts on different underlying stocks. What causes these differences, and how do we make sense of them?
In-the-money options cost more to purchase than out-of-the-money options with the same maturity. Intuitively, we can make sense of this by thinking about the intrinsic value. An in-the-money option has the potential to make money for the holder if it's exercised today whereas an out-of-the-money option is guaranteed to lose money if exercised.
Visually, we can graph the intrinsic value and extrinsic value of a call option as the stock price increases over time.
If we draw the same exact graph for a put option, it would look like this.
In both scenarios, in-the-money options have a much higher price than out-of-the-money options.
As an option buyer, we need to know what we are buying when we are looking at contracts with low prices. The low price could likely mean that we are buying extremely out-of-the-money options which are extremely risky if they have a short maturity date.
Option prices cost more for stocks with higher share prices than for stocks with lower share prices. Stocks with higher share prices represent bigger bets for options traders since the price movements are larger on a dollar basis.
For example, let's take a look at two stocks that have similar price movements but different share prices.
The price for an option on a higher-priced stock like $AMZN can often be unaffordable. If this is the case, the mistake we absolutely want to avoid is to get around this by buying super-out-of-the-money options on the same stock. While the price of these options is much cheaper, we can lose all our money very quickly depending on how soon the options mature.
In a previous lesson on implied volatility, we learned that high IV makes option prices expensive. We can imagine the relationship between IV and option price with the demand for insurance—during times of extreme uncertainty, investors want the insurance provided by options and are willing to pay more for the insurance.
When looking at an option's price, it's always a good idea to compare historical volatility with the current implied volatility. Buying an option when the current IV is much higher than the historical volatility means we are buying at the same time that other investors are shopping for insurance and can result in overpaying for our contracts. Likewise, selling options when IV is lower than historical volatility, means that we could be selling during the time that everyone is getting rid of their insurance. The market would be underpricing our options contract.
Understanding how to compare volatility is an advanced concept that is applied situationally. We will cover this topic in more detail in future lessons.
The biggest pitfall we want to avoid is to bargain bin shop for out-of-the-money options. Before we pull the trigger on a very cheap option, we should take a look at the break-even and the delta. This will help us gain an understanding of the likelihood that the option can be valuable.
A free tool to look up historical volatility.