[gTr]

Do you use some sort of an option pricing tool to see whether a said option is under or overpriced ?

Also thanks Cthree for your post on options and leverage.

magician

Virtually all options are overpriced. One of the variables that determines the price of an option is the expected volatility of the price of the underlying [security]: the more volatile the price of the underlying, the higher the price of both put and call options.

When you put the price of an option into a model - Black-Scholes, say - you can compute the volatility that would be necessary to justify that price; this is called the implied volatility. What you find is that the implied volatility of the underlying is almost always higher than the realized volatility; i.e., the actual price fluctuations that occur between the time you sell or buy the option and the expiration. If the implied volatility is higher than the realized volatility, the option price will be too high.

What does this mean? You should sell options. If you only sell deep out-of-the-money options you should make a ton of money with very little risk.

[gTr]

In order to sell options I have to have them so I have to buy them thus implied vol concept is going to cost me there. I have studied all about implied vol, vol smirk and smile etc. etc. but that is not what I was interrsted in.
What I was trying to ask Cthree was how to successfully price options in the REAL world.
I know most of the theoretical concepts but have little to no idea of their real world applications and use.

magician

No, you don't.

There is no fixed supply of options. If you want to sell a put option you simply write it, offer it on the market, and sell it.

I'd suggest using something like a Black-Scholes model; you can supply your own inputs for the risk-free rate and the volatility of the price of the underlying and the model will give you a fair price for put and call options.

What the model won't do, however, is ensure that the market offers you a fair price for put and call options. You might find an option that is, say, underpriced based on fundamentals (the output of your sophisticated, accurate model), but you're not going to make any money on it if the market continues to undervalue it; indeed, you could lose money if you buy a (fundamentally) undervalued option, only to find when you later try to sell it that the market has further undervalued it.

cthree

magician is correct. The price is a function of the implied volatility and the amount of time till expiration. I look for opportunities with a low premium (low volatility) but with a high potential for a quick move. It's hard to say that something won't happen so writing calls can be a little risky. Options allow you the opportunity to make very complicated trades which typically, in my experience, you just end up hanging yourself on. I try to stick to buying call and puts. The more complicated it gets the lower the probability of success IMO.

I don't like to pay more than about 4% for a call one month out 10% out of the money. That means (in August) I'd pay about $4 for a $110 October call with current underlaying stock price of $100. This is about normal.

The premium isn't really the most important thing to worry about because it all comes around. If you buy with a high premium you'll be selling with one too so it doesn't have any tangible effect on short term options. If you were buying LEAPs it would be more important.

I trade the option as a proxy for the underlaying stock. I don't get too bogged down in the option itself. It matters more to me that the underlying stock does what I want it to when I want it to and trust that the option proxy will follow suit. You don't need to get too heavily involved in the pricing and volatility of the options. It's not that complicated and like higher math you'll probably never use it in the real world.

cthree

Selling naked calls will eat into your available margin.

dyu626

Are you still holding on your APPL Oct 200 Calls? I might get in on it. Finally funded my Scottrade account lol.

[gTr]

This is the kind of advice I was looking for. Thank you

magician

So you only make half-a-ton of money.

AZDavid

I expect WaMu to get bailed out before year end.