How to find out if the option is undervalued or not?

M

mizhael

How to find out if the option is undervalued or not?

Hi all,

I have been observing the options for a while and I have a question about how to value the call/put options.

I know the Black Scholes formulae and understand how it was derived. However, there is a parameter called volatility that is tricky.

In order to calculate the fair value of the option, I need the volatility. But where do I find out the volatility? There can be two ways: one is to do a historical stock price analysis to obtain historical volatility; another is to back out from the BS formulae using historical option price, etc.
And perhaps there are more tricks here.

Anybody can give me some pointers? My goal is to find out which option is undervalued so I can buy or over-valued so I can sell. I am an individual(small) investor.

Thanks a lot!
 
Quote from mizhael:

...However, there is a parameter called volatility that is tricky...
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That's exactly the point. Volatility is a big smudge factor so there's no easy way to determine whether an option is over/undervalued.

You can look at historical volatility (aka statistical) and/or historical implied volatility and/or use something like GARCH or other model to estimate it, but in the end it is just an estimate and, once again, there's no easy way to determine it.
 
Over / under value is subjective in any case and its based on your assumption of the future volatility.


Buying perceived under valued and selling perceived over valued options is simple Implied Volatility trading. The problem is the assumptions you make and the fact that the perceived "edge" in over / under value has been shaved to the point where you have to trade large volume to make it profitable. As a retail investor you're not going to be able to do it on a cost basis alone.
 
There are some publications that list the most over/under priced options. I don't remember the names but they frequently pop up on yahoo finance. This might be the best information you will get for small retail trading. I think many of us just sell options with high IV and buy some further out options with less IV to make $ on the IV collapse. For me that often means buying leaps and shorting near month options 1-2 months out .
 
By the time a publication comes out the their subjective guess at over / under value has been filtered into the market.
 
Quote from dipper17:

Over / under value is subjective in any case and its based on your assumption of the future volatility.


Buying perceived under valued and selling perceived over valued options is simple Implied Volatility trading. The problem is the assumptions you make and the fact that the perceived "edge" in over / under value has been shaved to the point where you have to trade large volume to make it profitable. As a retail investor you're not going to be able to do it on a cost basis alone.
More...

The rational small retail investors won't invest in options at all. Am I right?
 
Quote from chrismontez:

There are some publications that list the most over/under priced options. I don't remember the names but they frequently pop up on yahoo finance. This might be the best information you will get for small retail trading. I think many of us just sell options with high IV and buy some further out options with less IV to make $ on the IV collapse. For me that often means buying leaps and shorting near month options 1-2 months out .
More...

Do you recall how they decide the over/under priced options?

What's the rationale behind this strategy: "I think many of us just sell options with high IV and buy some further out options with less IV to make $ on the IV collapse. "?

Could you please elaborate on "For me that often means buying leaps and shorting near month options 1-2 months out . "?
 
Quote from mizhael:

Do you recall how they decide the over/under priced options?

What's the rationale behind this strategy: "I think many of us just sell options with high IV and buy some further out options with less IV to make $ on the IV collapse. "?

Could you please elaborate on "For me that often means buying leaps and shorting near month options 1-2 months out . "?
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He's referring to long calendar spreads. Problem being, a high front month vol usually equates to a high decile across the term-structure. Vegas increase with duration, so there is no free-lunch. Be careful where you get your information.
 
Quote from mizhael:

The rational small retail investors won't invest in options at all. Am I right?
More...

I dont agree with you there. I would say that for a good % ( a subjective % not an objective calculation) of retail investors options are a reasonable way to enhance the returns of their portfolios. They're clearly not for every joe out there because they do take a fair degree of dedication to learn and maintain. Retail volume in US listed equity options has gone through the roof over the last 10 years. The efficiency in the access to the market has slashed the expense of getting into options significantly which lowers the barrier of entry for average investors.
 
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