Paying for Options: How Much Is Too Much?

When evaluating options picks, professionals will often refer to a particular contract as "too rich" and label another "cheap." What exactly are they talking about? And more importantly, how does the average investor know when an option isn't worth the cost or is a Filene's Basement kind of bargain.

That's the main issue addressed in this week's forum. You keep sending questions to the Options Forum and we'll keep answering them.

Here's one reader note on pricing.

I read your Saturday article; I have read a lot about options but never have I traded them.

What struck me about your article and what I don't have a grasp of is that when it comes to the price of an option.

I have read how they are priced, but what struck me from your article is how self-assured you were that the put for JDS Uniphase (JDSU) was a lot of money; I, on the other hand, would have no clue. So I really would like your input on this and maybe some direction for further inquiry or reading. When it comes to options, I have no sense of value.

Guy Lerner Louisville, KY

Guy,

A sense of value in the options markets often seems akin to true love: You can't describe it, really, but you know it when you find it.

Folks who tell you that, however, are copping out to a certain degree. There is some basic math you can do that will give you a handle on the actual value of your option.

To take a few steps back, an options price -- called the premium -- is determined by a combination of factors. Intrinsic value is the first and foremost. That's the amount by which the option is in the money. For instance, if Cisco (CSCO) was trading at 73, a May put option with a strike price of 75 would have 2 points of intrinsic value. Why then, we ask, is it trading for 6 5/8?

The rest of an option's premium is made up of the volatility expected by the market (called implied volatility), the time until expiration, and interest rates.

These can add tremendously to the cost of an option. For instance, if takeover rumors are swirling around a company, the implied volatility will likely get jacked up as well, and make those call options expensive. If you're trying to buy a LEAPS option (the acronym for long-term options that expire more than 12 months from the current date), you'll pay more because the time component is larger than in a short-date option that expires in 90 days or less.

That said, an option can be expensive and not be too expensive to buy.

Professionals spend millions of dollars and many years learning the intricacies of pricing options in a dynamic market, but for individuals, says John Power at the Chicago Board Options Exchange's Options Institute, calculating such theoretical values may not actually determine the option's value to the investor.

Here's an example of how valuable a put option could be if you really want it. On Wednesday morning, Cisco was at 75. The May 65 put -- which would give you the right to sell the stock at 65 no matter how much it falls -- costs 2 1/4.

But because the option won't have any intrinsic value until Cisco falls to 65, you may think 2 1/4 is a little rich. You may estimate your own implied volatility level and reach the conclusion that the theoretical value of the option is instead 2. "But by the time it gets to 2, the stock may be at 85, which makes the option theoretically more expensive," Power says.

But, if you decided to pay 2 1/4, it would've cost $225 (2 1/4 x 100 shares each options contract represents) to cover a $7,500 stock position. That's about 3% of the position. On top of that, you're limiting losses to 10 (the 75 stock price minus the 65 put's strike price) over the next roughly 60 days. By buying the 65 puts, you've capped your potential losses at $1,200 The total amount you could lose on the position is about $1,225 ($1,000 on the stock position and whatever premium you paid for the calls). On the upside, if Cisco hits 77 1/4 by the third Friday in May, you've broken even and the 2 1/4 you've paid for the put protection is covered; any move over 77 1/4 is gravy.

So, while Cisco's high implied volatility or the time component of buying a May option may make the puts seem expensive, on a pure dollar basis, it won't cost too much to get some cover. That's a key point for retail investors, Power says.

"Expensive means different things to different people," he says. "Do the pure dollars work for you as opposed to whether an option is theoretically expensive or cheap?"

Knowing a range, though, can help tremendously, he says. It can prevent an investor from buying an option that's been pumped up on rumors and has less of a chance of letting the investor break even. Even at-the-money call buys have been losers for investors who see the stock rise on a news event only to have the volatility drain out along with uncertainty.

There are tools that can help you find that range. You can download, for free, the Options Toolbox from the Options Industry Council's Web site or use the Chicago Board Options Exchange site for its Options Calculator.

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