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December 12, 2019 
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Do You Have A Good Option Play?

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 model.

Options Analysis

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 crash.

Ken Trester

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