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One of the biggest misconceptions in options trading is that lower premiums mean you’re getting a good deal.
After all, if an option that was trading at $5 suddenly halves in price, then you might think you’re buying it at a steal – with an even better potential payoff.
But successful option trading isn’t simply about how much you pay. It’s about the relationship between the option price and the risk the market is currently pricing in.
In fact, when you dive deeper into this relationship, you’ll see many examples where “cheap” options are overpriced and “expensive” options represent good value.
Misunderstanding this relationship can trip you up. So let’s dissect how things really work…
When professional traders look at options, one of the first things they check is implied volatility (IV). Implied volatility reflects the option market’s view on how much the underlying stock is expected to move over a given period.
When implied volatility is high, option premiums become more expensive (and vice versa). And there’s a reason for that…
Take, for example, a market maker selling you an option. The higher the volatility, the greater the risk that the underlying stock makes a larger move than expected. So naturally, the market maker wants more premium as compensation.
But the real risk – which we’re seeing right now – is lower implied volatility (and premiums). The danger arises when implied volatility is too low. In that environment, option sellers may not be receiving adequate compensation for the risk they’re taking on…
Consider the situation we’re seeing right now. Last Friday, the CBOE Volatility Index (VIX) closed at 15.3 – its lowest level since late January. Yet the latest Iranian peace deal has stalled, and oil prices remain stuck well above pre-conflict levels.
Plus, inflation is on the rise… and despite a pullback, Treasury yields are still tracking at multi-month highs. Yet the options market is currently suggesting investors aren’t particularly worried.
If volatility suddenly re-emerges, those seemingly cheap options we’re seeing right now could soon prove to be very expensive for option sellers and very valuable for option buyers.
That’s why professional traders compare option premiums against the risks lying beneath the surface… They make sure that premium accurately reflects the probability (and size) of future market moves.
I always pay close attention when volatility gets compressed. It’s telling me that investors are becoming increasingly comfortable about the future. And when that comfort turns into complacency, risks become hard to see.
But some of the best opportunities in options trading emerge when the market is too complacent. Right now, investors seem convinced that we’ll reach a peace deal in the Middle East, oil prices will move lower, and inflation pressures will begin to ease.
However, if those assumptions prove wrong, volatility can reprice very quickly. And if you’re positioned just right, you can reap the benefits.
Because in options trading, value isn’t found by simply buying what’s cheapest. It’s found by identifying where the market is mispricing uncertainty.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
