Select Options .com logo  

Evaluating Option Investment Opportunities

Predicting what the market won't do

Today we are bombarded with so much data, that the data paralyzes our decision making. One effective way to break this paralysis is to distance your mind from the details and focus on the big picture. The three most important determinations you must make are "Which direction is the market heading?", "Will the stock of interest outperform or under-perform the market?", and "How long can this trend be expected to continue?". Your initial answers to these question should be taken from your gut. Consider all the news you have heard and make your best guess. The answers to these questions will guide the selection and analysis process. Answers these questions in simple terms. For market direction make three simple categories:
  1.  The market will move significantly upward
  2.  The market will stay about the same
  3.  The market will move significantly downward

Similarly, for the stock being analyzed, make three simple categories:

  1.  The stock will outperform the market
  2.  The stock will perform in line with the market
  3.  The stock will under-perform the market

The answer to the first question establishes a systematic bias that must be applied to any individual investment that is evaluated. Now, considering both of the above answers, choose the answer from the list below that seems the most correct.

  1. The stock is likely to move significantly higher. (Very Bullish)
  2. The stock is not likely to move significantly lower (Bullish).
  3. The stock is not likely to move significantly higher or lower. (Stagnant)
  4. The stock is not likely to move significantly higher. (Bearish)
  5. The stock is likely to move significantly lower. (Very Bearish)
  6. The stock is likely to move significantly higher or significantly lower, but it is not likely to stay where it is. (Volatile)

Note that some of these categories are very broad. For example, the Bullish category covers stock that increase significantly, stocks that increase slightly, stocks that remains unchanged, and stocks that decrease slightly. An option investment can be built to take advantage of price movement falling into any answer categories. The investment vehicles listed below are defined in Term Definitions and described in detail in the analysis sections of this tutorial.

Very Bullish 
Long Calls
Short Puts
Bull Spreads
Covered Calls
Buy Write
Sell Write
Bear Spreads
Very Bearish
Long Puts (speculative)
Long Puts (insurance on portfolio stock)
Volatility Spread (no analyzer support at this time.)

The option vehicles listed above can often be used effectively both one degree more bullish and one degree more bearish than the category they are listed depending on their safety margin (discussed below).

The next step is to determine the timeframe of the investment. Considering your answer to the above question, answer "How long do I expect this trend be expected to continue?". Much option investing is done utilizing one to three month time frames because that is as far as the investor feels comfortable about his/her trend prediction. Choose a time frame of investments that you would consider. If your not comfortable with your trend prediction beyond two months, then request analysis of only one and two month options.

Next choose your minimum safety margin for each time period. You may decide that you need a larger safety margin for longer term investments. For example, if you specify a safety margin of "5,9" on a bullish investment, you are stating that your only interested in one month option investments that can tolerate a 5% bearish move, and two month option investments that can tolerate a 9% bearish move. The selection of safety margin also establishes the definition of the word "significantly" as used in the above investment category descriptions.

Reducing your safety margin generally increases your potential profit and increases the selection of option investments. Increasing the safety margin yields good probabilities of success, but selection will be limited and the investor may have to actively search for these investments. The tools on this web site are constructed to help you find and analyze these opportunities.

Identifying good values

Mathematicians have worked hard to find ways of objectively calculating the value of any specific option investment. In a perfect world, these calculated prices would be fair (benefiting neither buyer nor seller). In 1973, Fischer Black and Myron Scholes published their Nobel Prize winning equations that calculated the values of Call and Put options. However, option prices often differ from these calculated Black-Scholes Model prices. "Special situational knowledge" drives a buyer or seller to deviate from the Black-Scholes price. Options trading higher than their Black-Scholes price are considered overvalued. Options trading below their Black-Scholes price are considered undervalued. If you're a seller, look for overvalued opportunities. If you're a buyer, look for undervalued opportunities. The tools on this web site help you identify these opportunities. Once you identify one of these opportunities, research the company's situation. There may a good reason for the price to differ.

Option prices are determined by the probabilities of various price movements of the underlying stock or index. To make informed decisions regarding whether an option position is over or under valued, you should have some understanding of how mathematical probability is used to determine option prices. The next section provides a practical introduction.

Next Section: A Practical Introduction to Mathematical Probability

Previous Section: Managing Risk

RAF Research Link
Delayed Market Data provided by DTN Market Access.
© Copyright 2006 RAF Research. All rights reserved.        Site Use Agreement | Privacy Policy
The data and information accessible on this web site is provided "as is" and there may be delays, omissions or inaccuracies in such information and data. RAF Research, its affiliates, agents, information providers, and licensors cannot and do not guarantee the accuracy, sequence, completeness, timeliness, merchantability or fitness for a particular purpose of the information or data made available through the site. By using this site, the user agrees that the user has read, and agrees to be bound by the "Site Use Agreement".