From Our October 2015 E-mail Archives: Today, our Our Head Trader, Robb, answers a question from one of Maverick's traders about when an option becomes "too expensive."*
-----Original Message-----
From: Alonzo D.
Subject: Trader Question!
Hi Robb,
You often speak of paying too much for an option. What is the max that you are willing to pay in time value for an option that you go long on? Long Call/Put vs. one leg of a spread.
Thanks,
Alonzo
-----Reply Message-----
Hi Alonzo,
As you know, options prices are due to time and volatility. Since time is fixed, volatility is really the thing that will increase the price of the option. So, Implied Volatility (IV) will be the thing that makes it “too expensive.” However, IV is simply a result of supply and demand for the option – using the Historical Volatility (HV) of the underlying.
Efficient market theory believes that the market price is the “correct price.”If you believe the efficient market theory (which I do), then every option is priced correctly. Thus, for me as a trader, “too expensive” simply means my Risk/Reward is no longer worth it.
Let me give you an example.
CMG has earnings tonight [October 20, 2015] after the close. Let’s say I wanted to buy at the money long calls going into the report, as follows:
- CMG Price: $712.52
- CMG November (next month) 710 Call Price: $35.00
When I am building the trade, I have to figure out T.E.S.T. (Timeframe, Entry, Stop and Target) and run the numbers. I have to plan out my max risk (projected or absolute) and my reward potential. Let’s use the following numbers for CMG:
- Timeframe: 2-3 days
- Entry: 712.52
- Stop (abandon or adjust price): 642.52 – I simply used ATM long calls and puts added together to get the projected move of CMG after earnings.
- Target: 857.50 – I used a 61.8% Fibonacci extension to get this number. Remember, though, that targets are nothing more than slightly educated guesses as to where this is going.
Now, let’s calculate the Risk/Reward of the long call play with exiting at both our stop and target prices. I used a risk graphing calculator to get these projected values in 2 days. I also used a 50% drop in IV since that is fairly typical with an active stock after earnings.
- Risk: $3,427 (you are basically at max absolute risk since the original call price was $35)
- Potential Reward: $10,750 (projected value at 857 CMG price after 2 days and 50% drop in IV)
- Reward/Risk Ratio: 3.13
We are finally at the bottom line where we decide whether the option is “too expensive.” If it can’t justify the risk with at least a 2X reward, then this is when I say the option is too expensive.
As you can see, things like stop and target prices are subjective to each trader and can lead to different numbers. As we always say, “Consistency is the most important thing in trading. Even though two different traders use different numbers, they should have close to the same results after thousands of trades.
So, after my long, detailed answer, the short answer is when there is not enough upside to justify the price of the option.
Hope this helps,
Robb
* NOTE: Some original wording has been modified for legibility.
