2. How to value options?

Hello

Welcome to Tiger Academy - 「Practical Operation with the App」episode 2.

According to feedback from many friends before, there are times when the direction of buying options is correct, but the returns are low, and sometimes even losses are incurred.

What Tiger Academy wants to tell everyone is that sometimes the direction of options' rise and fall may not necessarily align with the rise and fall of stocks. Taking buying call options as an example, if the stock price rises but the call option price still falls, there are basically two reasons. First, the delta and gamma gains are smaller than the time value decay brought by theta. For example, for call options on the Nasdaq 100 ETF expiring on January 12, 2024, even though the underlying price rose by 0.12% on the day, the call option prices mostly decreased.

For this situation, Tiger Academy suggests everyone to be cautious, especially with options approaching their expiration date, as the time value tends to undergo accelerated decay. Therefore, if the expected stock price movement is not substantial, it's advisable to avoid being the buyer.

Another reason is the decrease in volatility, known as IV crash, which causes a corresponding decline in option prices. For example, consider the call option with a strike price of $146 expiring on January 12, 2024, for Amazon. On a day when Amazon's stock price increased by 0.46%, the option price decreased by 1.25%. This is primarily due to the implied volatility of the option dropping from 25.65% to 22.78%.

The fundamental reason for encountering such issues is that your options were purchased at a high price. Now the question arises, how can you determine if the options you bought are overpriced? This involves the valuation of options.

In this session, Tiger academy will introduce how to estimate the value of options in your possession using the APP.

Since the price of options is influenced not only by the expiration date, strike price, and interest rate but also by volatility, where higher volatility leads to higher option prices and greater valuation deviations, buying options can result in being directionally correct but still incurring losses.

Therefore, the core of option valuation lies in comparing the deviation of volatilities. If implied volatility deviates significantly from historical volatility, the option may be overvalued or undervalued. Specifically, if implied volatility is greater than historical volatility, the option is overvalued; if implied volatility is less than historical volatility, the option is undervalued. How can you check this?

You can open the APP, select the option you want to examine in the option chain, click to enter the market interface for that option, then scroll down to find the implied volatility curve for that option. If the implied volatility curve is significantly higher than the historical volatility curve, it indicates overvaluation; conversely, if it is lower, it suggests undervaluation.

Certainly, we can also use the price calculation feature by inputting our predictions for future stock prices and volatility into the calculator. The app will then automatically calculate the theoretical value of the option for us in the future.

In conclusion, when option prices are overvalued, it's advisable to avoid being a buyer and, if suitable, consider being a seller. Conversely, when option prices are undervalued, the opposite holds true.

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