Option Pricing

Carrying the nickname of the Option Addict means that by law I am required to talk about options at least once in a while. You’ll see my archives are full of good stuff like this, but today I am going to go back and talk about some key points to consider when evaluating option prices.

Always remember that shopping for options is like shopping for anything else; you get what you pay for. Cheaper options are of lesser quality and expensive options are of better quality. I will define quality as…

Increased sensitivity to price movements

Decreased sensitivity to time decay

Decreased sensitivity to implied volatility


As a buyer of an option, this is what you are looking for. Since time decay and volatility are typically more of an enemy than a friend, you want to defeat their ill intent. This is why in the money options are so valuable. You get to leverage the stock at a fraction of the cost, while not having to put up with the problems that time decay and implied volatility present.

The downside?

They are so damn expensive! And if the stock moves against you, delta isn’t all that appealing on the flipside.

“So Jeff, if what you are saying is truth, which we know you speak, why do you always trade out-the-money options?”

Let me give you the considerations of selecting an option first.

#1- Expected price movement.

#2- Expected time frame

#3- Expected change in volatility

#4- Expected probability of success

#5- Expected risk

#6- Source of trade recommendation


Expected Price Movement

The first and most important consideration is what you are expecting the stock price to do. If you are staring down the barrel of a breakout, big shift in momentum or just a big price swing in general, you can afford to take on more risk. The reason I trade a lot of out-the-money options is because I try to put myself in front of big price moves. Despite the out-the-money option being of lesser quality and lower probability, I see tremendous returns in exchange for an insignificant cost. Even though these trades start off with an insignificant sensitivity to price movement, a heavier gamma gives me comfort in the fact that if I am right in my price prediction, my sensitivity will increase dramatically.

Expected Time Frame

The quicker my stock moves, the lesser time decay becomes a factor. I always encourage traders to buy adequate time, and even when in doubt, to go further out! For those that buy short dated options, you are in a race against time. This means you stock needs to move in larger amounts to offset this loss in time value. To enhance this part of your selection process, only buy short dated options on stocks that make quick moves. And always default to buying more time than you need. However, don’t buy TOO MUCH TIME! I loathe long dated options.

Expected Change in Volatility

I hammer on this in most of my option courses and classes since volatility is a major player in the selection process. I have several posts that expand on this in greater detail. Click here to get started.

Expected Probability of Success

Look at delta as a measurement of probability. This means that an out-the-money option will have the smallest chance of success, while an in-the-money option carries the greatest chance of success. As always, a higher probability comes with a lower reward while a lower probability of success comes with a higher reward.

Expected Risk

Always pay close attention to what is really at stake in the trade. This can be determined in several ways. I like to consider the drop I am willing to take in the stock price, and translate that into the general impact in the option premium. If you use stops, consider the difference between the purchase price of the contract and where your stop is set. Or if you are a gunslinger, consider the full option premium.

Source of the Recommendation

It is easy to select an option when it comes from a credible source.

This will probably open up a a big can of worms, so I will try to be as responsive as possible to incoming questions. For those that struggle with selecting options, hopefully this can act as a checklist when making your choice.

Recommendation: If you are like me, you hate reading long posts.

Long: Short posts

Short: Long posts

Disclaimer: I love options

Excellent information, as always, Jeff.

My rules kept me from getting into NILE after it broke out this morning, but now it looks like it may be coming back down closer to $96 which was my line in the sand.

Any input, anyone!?!

THIS post is recorded in my "Kohler Notes" file to be read over and over again ....

Great stuff - Jeff! Thanks much!

DavidS,

I posted this on the last thread but I type so slow we cot the clean cups call while doing it. Sooo..I put it here too.


My $.02 on SCHN for what it is worth. i drew a diag support line starting on 8/28 with a touch on 9/12 and a horiz support in the area of $64. According to what IT teaches in the 3 day live class, to increase the probability of the trade and see what it will do in the short term you will need to see a bounce off of either the horizontal or diagonal support. IT defines a bounce as the point when there is a close above the high of the wick on the lowest day (including the wick).

For me I don't think there is any way to tell whether this is going to take off from here or coming in to touch the diagonal resistance.
I'd wait.

Again...my $.02

Hey Peter. I don't think I advised you to chill. I actually bought them as well earlier today. Mine are January 45s but I'm in there too. Here's hoping for the best.

Man, when I hear all of that over again, it makes it seem so complicated.

The best option advice I've got, which you gave me Jeff, was in point form

Delta, Gamma, Theta, Vega, Rho, At the money options are always the highest, better to go ITM or OTM.

Good to be reminded..... thanks for the post

Jeff--Awesome. Thanks.

Jeff,

Thanks for the great info as always.

Dan

Jeff, this is great info as always. I have been buying mostly ITM lately as I have been in and out of trades a lot quicker and trying to just pick up some small moves.

Are those saucers developing on the indices, or are they just happy to see me?

Thanks for the post Jeff. You've basically already written a book on options on this blog- what a service! Hopefully you are repaid in some way through your good Karma which is at an all time high.

Tim, it was the other Wize One, Brett, that mentioned perhaps he would wait to see more price confirmation on VAR.

(not so) Young Grasshopper
AKA Peter

Krystal, I'm not sure what your rules are on this one. Bounce trade or breakout trade ? What are you using horizontal support on the breakout. Daignal support from where ? As short as the low on 9/10. More info might help to give a comment.

Great info, thanks Jeff.

Jamie

Always thinking about the right side of the chart, and pointing things out in advance....nice Brett.

Arty, the SDS is like taking an antacid. Keeps you nice and refresshed when on a day like today some of my calls are bleeding off a little.

Jamie

Yay! You're the best! Thanks for taking the time to post this!

Lara

Jamie,

Horizontal resistance at about $95.70ish for a breakout trade.

My rules would not allow me to get in this morning when I caught it at about $98 (given my $95.70 line in the sand), but as it trails off to end the day, it may provide another possible entry point for me...

What do you think?

Krystal

Jeff, this information is of great value to me. I printed a copy and will keep it by my computer as an important reference source. It helps when I can see how others think to make this all work. Still learning, learning...
Kelly

Jeff,

Thanks for the invaluable option info...I too will print it and keep it nearby!

Kohler,
You have HUGE GAME. Thanks for the post I am having this tatooed on my leg for further reference with trading!

FTEK is crying out to be shorted!

ARTY

Jeff:
Thanks for the post. I normally trade ITM, but looking back at my purchase of BIDU I notice I bought ATM (primarily due to cost). I did well due to the strength of the breakout, but OTM was probably more appropriate. Thanks for the checklist. I will try to incorporate the checklist points into my trading rules.

Jeff,

Great refresher on options. Thanks!
I've been buying deep ITM lately to neutralize the IV.

--Patti

Arty,

If you do that, I will foot the bill for the ink. And fly you to Miami to see if we can get it on TV.

Get it in script style, similar to T-Mac's tat on his arm. I like that look.

Jeff, thank you for the info.

Rimm is coming back to test the sym triangle breakout. Might be a good REE.

Barbara

Jeff,I am glad you never get tired of talking about options.

Patti - also CEO, China National Oil. Look at a line chart of the last month. Ridiculous.

SFM

Krystal, 30 minutes to go and the volume is really not there. I'd wait. Thats MY opinion though. I like the trend and will keep it on my radar for an entry.

Jamie

Thanks Susan, I'll add CEO to my list.

--Patti

Jeff,

Thanks for the excellent article.

Has anyone noticed REE on CNQ? It retested 74-ish and seems to be holding above on good volume.

VeroBarbara

So the real question is:

When is the NUVA buyout going to be announced???

(just kidding).

I noticed that on my radar Vero. I also noticed DVA at REE

VeroBarbara,

The dec $65 calls on CNQ are a steal. I'm in.

Joel R.

Jamie,

Thanks so much.

I had already decided that I wasn't going to take this trade. Somehow, I seem to lack conviction in it for the moment.

I did, however, get into a Nov $105 paper trade of it earlier in the day (one contract to keep it simple) and I'm up $45 in it! HA!

Dinner on me?...

Krystal

PCP 52 week high, with volume to boot. Unfortunately, I feel a little too late to the party. Hopefully it consolidates here and offers a safer entry.

Joel R.

Hi Jeff,
Thanks for another fine lesson. I have been a long time reader but finally decided to log on and get involved as this might be the best way to learn is to participate.
Thank you for the insight and all the hard work you put into this page. This is one of only two trading blogs that i read almost daily.
again
Thank you,
Jione

Brett,
Call me crazy or coward but I just took profits on VDSI. I think it will go back to 32.50 at which point I might re-enter. YMMV.

ELON...

Tick, tick tick...

It's like a timebomb. Check out the massive buying into the close. They know it, you know it, and I know it.

Okay, coward.

DVA - (not sure who posted about this) I don't see that as REE. I see an overextended stock that is flagging and until it breaks out of the flag, it isn't REE. At least not for me. Again, Ymmv.

What is REE?

ELON - I hope you're right. I back up the truck for this one yesterday.

REE is this blog's speak for "enter at your exit".

Jeff,
I have awoken from the sleep of the dead... and what a post to wake up to!!! I will do ARTY one better and have it tattooed on my forehead (which, I should point out, is big enough for the whole thing) BACKWARDS!! That way I can look in the mirror instead of rolling up my pant legs and looking like I'm some demonic hitch-hiker.

Thanks for a great post.

IRIS my case.

REE is something the blog has adopted from my esteemed colleague Raimo, who is now atop a Pennsylvania mountain killing God-knows-what with God-knows-what. Basically it means, "A good entry," but it wouldn't be nearly as catchy.

OH!

I thought the letters REE were an acronym for something!

Thanks Doji Girl...

Jione,

Thanks for becoming an official member. I appreciate it.

Jeff

Another one of those bizarre days. The Dow's down 52 points and my RRSP is up almost 4%. Had a heart attack when I looked at my options account as it showed I was down about 30% today!!! Interactive Brokers must have forgotton to pay someone's bill... I was really only down $11. Fortunately that's not 30% of my account.

REE = Raimo Entry/Exit

NOV, IVGN, and DRYS kept my acct afloat on a day when almost everything else was pulling back a little.......it is amazing to me how WYNN hit it's price pattern target and is pulling back, i missed the entry on this one so i am patiently waiting for the next buy signal....congrats to everyone who took this trade!!!

Hey Tim, or anyone who's got their profile up on Jeff's "My Option Addicts" part of the page.

I've got my stupid picture up there but for some reason "Chris and Catherine" doesn't come up. Everyone else has their name up there but me.

I feel retarted.

Hey Chris, I see your name up there. What browser are you using.

Whoever mentioned CNQ, I got in yesterday around 74 so today is looking sweet!

Chris-
The reason your name doesn't show up is because you're logged in. My name doesn't come up either under my picture but it's because I'm logged in. If I wasn't my name would show up.

liz

Chris-
I hope that makes sense.


Tim-
I got into CNQ yesterday as well.

liz

KAY-LO,
That is your new Basketball name! Ink up dude and maybe we can do a Miami Ink and So You think You Can Shoot the Rock combo!

Also what should I do about GRMN?

HAAAAA I am the dumbass holding some September paper.

C2 Don't make me shave my back and get the Kohler archive tat back there!

Finally is it possible that VDSI is actually below REE?

Cheers,
ARTY

Great post Jeff, very concise summary and very helpful when a refresher is needed.

Today's market action almost seemed necessary, a pause before options expiration, makes me think there will be an up day tomorrow for OE, but of course thats just an opinion, it's hard for me to back that up techincally.

One thing I have lost sight of even though I maybe shouldn't care but I used to take into account where I thought a stock would get pinned for OE, my two positions AAPL and GRMN, will be interesting to watch. AAPL is right at 140 so I'd assume little action tomorrow. GRMN is more interesting because its closer to the 105 than 110.

what are people watching on the vix to get back into long options? It has been frustrating watching my technical and time analysis be correct but still be down money due to volatility dropping, any tips?

thanks

Ben

Brett - How do you find these gems? (IRIS). I wish I had known about it yesterday. Doesn't it seem a bit too far off REE now? $1.00 may not seem alot but on this stock it is 5%.

Tim, I'm on IE (don't yell at me.) I've been long CNQ for a while. Just a small holding in my RRSP.

Liz, thanks for that. Now I know. Hey, nice new picture you've put up. You look happy to see me. We should all post pictures of ourselves in our OA Gear. Outerwear only, please.

Erin,
Thank you for holding my hand into the IRIS, and ELON trades.

You had me with your new photo.

Cheers,
ARTY

Hey Arty, don't sweat the GRMN paper. Tomorrow's still a long way off.

DG I think IRIS is too far gone... but I looked at it yesterday and it had shot up above 20 and then pulled back as the day ended. To me, it looked like it didn't have any steam to break through 20 and might be ready to pull back. It needed today's break-out to confirm... but now it seems a bit overextended to pull the trigger (to coin a phrase.) If the market was in a severe uptrend, I'd probably be more inclined to take the trade. For me... there are better openings in other places.

Brett,
While we're sharing the love... thanks for ELON and BPHX. Although I got into both stocks late, I've made a few bucks and I like them both longterm. They are part of the reason for my 4% increase in my RRSP today. Your willingness to share your insights and humour are an inspiration to us all.

Hey, an inspiration (do you like my seque?) I had in Vegas was to hold the OA meeting there. It's such a cool place!! and so many bizarre things to see!! I had a flight attendant on the flight home (a boy) who had been there on an all-expense paid trip by some Producer (yet another boy.) I won't go into the sordid details... but it was... shall we say... bizarre. And expensive.

Chris and Christopher,

No thanks necessary. Pay it forward.

Clean Cups, y'all.

I vote yes to a Vegas OA meeting as well. :-) Preferrably around oct 18th, lol. Jk, flights are now pretty cheap like 100 round trip from here so any time would probably work, well on a weekend when I don't have school.

Ben

During the last couple of weeks, I have been working more off and on and not keeping up with the blog here. I have an idea of what the REE is from reading all the posts, but what does it stand for and where is the original explaination post. Can someone point me in the right direction. thanks

Barry

Wow! some of you guys had fun tonight with the sign up's LOL

Fellow Option Addicts,

Like you, I believe I become a better trader by reviewing Jeff's blog daily. It has come to be my understanding and belief that correctly forecasting price movement, time frame, and volatility change is the key to choosing the correct option strategy in a particular situation. Consequently, I was pleased to read Jeff's Option Pricing article today. I highly recommend you print it out along with the link to the discussion of implied volatility and reread them periodicly. For more information on this 3 part forecast, I recommend James Bittman's inexpensive, but informative DVD, "Advanced Strategies for Option Trading Success", available from Traders Library.

Thanks Jeff for ALL you do for us!

Jeff Look
Kent, WA

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About me

  • I'm Option Addict
  • From Saratoga Springs, Utah, United States
  • I am a professional trader and an instructor for Investools. I've had relations with the markets for 9 years. Born in Concord, CA, but reside in Saratoga Springs, Utah. Father of THREE, Husband of one.
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