Steve, you stated Cisco (CSCO) February options were "rich" but 55 cents before commissions is not very much. American Pharmaceuticals Partners (APPX) options are very rich, for example, but stocks like Cisco have very small premiums. -- F.A.
Remember, when discussing the price of anything, "expensive" and "cheap" are relative terms. When my wife buys a pair of shoes for $300, the purchase seems very expensive. When she explains that $300 was a 50%-off sale price, it can be considered a
bargain -- though still outrageous to my mind.
While there is always room for some subjective interpretation, determining the "fair" value of an option, and therefore its relative "cheapness," is much easier than for a pair of shoes, believe it or not.
First and foremost, one should pretty much disregard the absolute dollar value or price tag of an option. What is more important is the option's current price relative to its past or pricing history. The best gauge and the real measure of an option's "richness" is the implied volatility.
Currently, Cisco February at-the-money options sport an implied volatility of 32%. By most measures this makes them expensive in that:
- The 30-day real or historical volatility of the underlying stock is just 20% because shares of Cisco have traded in a narrow range between $18 and $20 for the last three months.
Implied volatility on the options has increased from 25% a month ago to the current 32% reading, even as the historic volatility on the stock has declined from 29% to the above-mentioned 20% during the same time period.
The current implied volatility is above the midpoint of the 52-week range, a low of 21% recorded on Dec. 22, 2004, and a high of 45.5% hit on Jan. 30, 2004.
Remember that you're selling an option for 55 cents, or $55 per contract because one option contract represents 100 shares, so there is a 100 multiplier for calculating the dollar value of an equity option. As this reader mentions, that hardly seems worthwhile when commissions are included, especially if you are doing only a few contracts. But that by no means makes them cheap or a bargain to purchase. With Cisco trading at $18.90, the February $20 calls are now priced at 40 cents. They may cost less than they did a week ago but I still think they look relatively expensive and can be considered "rich" given both the stock's historical price pattern and premiums usually offered in the options.
prior column made no reference to American Pharmaceutical Partners, I cannot disagree with the reader that its options look extremely expensive: The January at-the-money options currently sport an implied volatility in the 165% range. That is well above the stock's 30-day historic volatility of 58%. It also represents a 52-week high as people brace for a decision due out in the next few days by U.S. drug regulators concerning the company's breast-cancer drug Abraxane. Note that the implied volatility of February options is significantly lower at 105%, creating a steep
volatility skew typically associated with anticipation of a price-moving news event.
With American Pharma trading at $34 and the January $35 straddle at $10 ($4.50 for the call and $5.50 for the put), its options certainly are expensive in both absolute and relative terms compared to Cisco's. But be aware that shares of American Pharma have traded between $21 and $41 in just the last two-month period. I'm not sure I'd feel comfortable buying or selling those options outright. A spread, which removes some of the vega, or volatility risk, might be a more prudent way to play a wild card such as a drug approval.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to