How to Tell If an Option Contract Is Cheap Enough to Buy

By Lee Lowell  |  March 20, 2019

I try to show readers that the options market, when approached correctly, is far more profitable and less scary/risky than they have been led to believe. I do this by putting out real world examples of how to do this… and by answering your questions. A common question I hear concerns the “volatility” component that helps make up the price of an option. It it’s a tricky concept to grasp.

A newcomer to the options trading game would naturally assume that an option is cheap or expensive based purely on its actual dollar amount. But did you know that an option that costs $1 per contract might actually be more “expensive” than an option that costs $5 per contract?

In the option’s world, expensive or cheap isn’t based on the dollar amount. Rather, it’s based on the volatility level.

Let me explain…

What Makes Up an Option’s Price?

There are six core components that help give an option its value:

  1. Price of the underlying stock
  2. Strike price of the option contract
  3. Days until expiration
  4. Volatility
  5. Interest rates
  6. Dividends

As I’ve discussed in previous articles, the first four components are the most crucial, so interest rates and dividends are a non-factor.

The first three in the list are easily measurable and identifiable. Only “volatility” is the wildcard and open to interpretation. So let’s interpret it.

The Wildcard

Volatility, as it applies to options trading, is a measure of how erratic (or not) a stock has been over some period in the past, and how erratic (or not) it’s expected to be over some period in the future. Once that erratic-ness has been measured and calculated, it can be added into the option pricing formula.

So, it’s correct to assume that stocks that fluctuate in large ranges will have a higher volatility component than stocks that are stable.

Each stock has its own volatility component, and by studying where on the scale it currently resides, can tell you whether its options contracts are cheap or expensive on an historical basis. This is also a great indicator of whether you’re getting a bargain if you’re an option buyer — like my colleague Adam O’Dell is in his Cycle 9 Alert service —or a seller.

Where to Get Volatility Data

One of the best places for options and volatility data is at ivolatility.com

To get an idea of a stock’s volatility, look at a volatility chart like the ones shown below.

This is Aflac’s (NYSE: AFL) 1-year volatility

These are volatility charts. Do not confuse them with regular stock price charts. They are different.

As you can see, Tesla is a more volatile stock on an absolute level. Its numbers are larger, and its volatility spans from a low of 35% to a high of 90%.

Aflac, on the other hand, has cheaper absolute numbers, and its volatility spans from 8% to 32%.

The blue and orange lines represent different measures of volatility, but both trend in the same direction for the most part.

So, do the charts tell us that TSLA is more erratic than AFL, and hence, its options are more expensive?

Not necessarily.

Yes, Tesla’s stock price may fluctuate more compared to Aflac’s, but the key is to compare the volatility highs and lows within each stock itself. Lower volatility levels will yield cheaper option prices, but it’s useless to compare one stock to another. If you are an option buyer, your goal is to buy when volatility is cheap compared to its past.

At the moment, it looks as though both Aflac and Tesla’s options are on the cheap side and could be ripe for option-buying strategies, whereas October (for TSLA) and January (for AFL) were expensive periods.

The Proof Is in the Calculations

How do we really know that volatility levels can affect an option’s price? Well, let’s take a look.

Using an option calculator, the only input on the left-hand side that was altered was TSLA’s volatility component, which was changed from 40% to 80%. These levels represent high and low points from its volatility chart.

Clearly, doubling the volatility component also doubled the price of the call option.

With the $100 option multiplier, the $275 strike call option would cost $2,095 when volatility was cheap or $4,271 when volatility was expensive.

That’s a huge difference.

Using a comparable scenario with Aflac (not shown), its option prices from low to high volatility levels would yield a range of $35 to $326. That’s thousands of dollars less than Tesla’s options cost, but it doesn’t necessarily mean that TSLA’s options are more expensive.

In the option’s world, “cheap” or “expensive” refers to volatility levels, and it is stock (ETF, commodity, bond) specific.

To conclude, when looking to buy or sell an option, always check the volatility levels. It can mean the difference between paying retail or paying wholesale.

Until next time…

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Lee Lowell

A former Wall Street insider and floor trader, Lee Lowell has worked in the market for nearly 30 years now. He began his option trading career in 1991on the floor of the New York Mercantile Exchange (NYMEX) in New York City.MORE FROM AUTHOR