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.
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
- The market will move significantly upward
- The market will stay
about the same
- The market will move significantly downward
Similarly, for the stock being analyzed, make three simple categories:
- The stock will outperform the market
- The stock will perform in line with the market
- The stock will under-perform the market
The answer to the first question establishes a systematic bias that
applied to any
that is evaluated.
Now, considering both of the above answers, choose the answer
from the list below that seems the most correct.
- The stock is likely to move significantly higher. (Very Bullish)
- The stock is not likely to move significantly lower (Bullish).
- The stock is not likely to move significantly higher or lower. (Stagnant)
- The stock is not likely to move significantly higher. (Bearish)
- The stock is likely to move significantly lower. (Very Bearish)
- The stock is likely to move significantly higher or significantly
lower, but it is not likely to stay where it is.
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
vehicles listed below are defined in Term
Definitions and described in detail in the analysis sections of
- 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
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
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.
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
on this web site are constructed to help you find and analyze these
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