Most option investors spend a lot of time picking a stock
or commodity but little time analyzing their underlying options. They
take what I call the "any horse in the barn" approach to selecting
options and pay the consequences with a poor risk-reward play.
The beauty of trading options is that you can scientifically
analyze them and know decisively whether you have a good or bad play.
You can mathematically measure whether an option is overvalued or undervalued
and what your probability of profit will be.
The validity of this approach to option trading was confirmed
when in 1997, Myron Scholes and Robert Merton won the Nobel prize in Economics
for developing the Black-Scholes option pricing model.
This is the pricing model I have used to identify undervalued
options since 1973, when listed options began trading. The option pricing
tables in my book, The Complete
Option Player, were generated using this model. And Option
Master (R), my options software, also incorporates the Black-Scholes
The successful trader always analyzes an option position
before he makes a trade. The true professional is always looking for that
scientific or mathematical advantage. When he finds a good advantage he
pounces on it. If there is no advantage he passes on the trade.
The first step in analyzing an option is to see if its
undervalued or overvalued. There are two approaches you can follow.
You can compare the present implied volatility of an
option to past implied volatilities of options on the same underlying
issue. If the present implied is lower, the option is undervalued.
Another approach is to determine the fair value of an
option using a pricing model, such as the Black-Scholes model.
If you are buying options you want to make sure that
it has a good probability of profit. For example, if an option you select
only shows a 10% chance of profiting, don't buy it! This kind of analysis
will get you off some bad money-losing -- option plays.
Another measure of the quality of an option play is an
option's delta. The delta measures the percent an option will move when
the underlying stock moves 1 point. For example, if the delta for a call
option ls .5, lt will move up 1/2 of a point if the stock moves up 1 point.
If you are buying options you want a high delta, and if you are writing
options, you want a low delta.
A third measure to look at when you are comparing short-term
option plays is the Percent to Double. In other words, how far does a
stock, index or futures have to rise or fall to cause the option to double
in price? The smaller the move required the better the play.
When you need to know the probability of a stock or index
hitting a target price or stop-Ioss point during the life of the option,
you need to carry out a different form of analysis. You need to simulate
the stock or index price action. A typical mathematical formula will not
work, but a simulator will do the job. One of the few software programs
that has a Price Simulator is Option
Master Deluxe, which can also carry out all of the other analysis
we just mentioned.
The more options analysis that you do the more successful
you will be. But if you fly by the seat of your pants you will surely