- 1997: Volume 6, No. 1 When Is An Option Overvalued?

When options are referred to as "undervalued" or "overvalued," this is a relative measure of comparing implied (current) option volatility of the closest to expiration options (having at least two weeks to expiration) to the historical (past) option volatility of these same options. It is important to consider premium disparity between strike prices and months of related options. In this case, even if an option may not be overvalued on an historical basis, it may be overvalued as to other options in its group.

For example, in October 1996, Ratio Option Positions in the S&P 500-purchasing close-to-the-money puts and selling multiple out-of-the-money puts, because implied option volatility for the far out-of-the-money puts was trading at 30%, 100% higher than the at-the-money options. Another example of this was in the coffee option market in June-July, where implied volatility was about 40% (near average historically), but some out of the money call options were trading at 100%+, (250% higher), providing great opportunities for Ratio Spreads.

Another way that an option can be overvalued is when the implied volatility of the option is trading at higher levels than the statistical volatility of the futures contract. For example, in mid-December, the implied volatility of the S&P options was almost 25% higher than the statistical (futures) volatility; this means that the options were overvalued compared to the futures. However, what made these positions even better was that implied volatility was 20% higher than historical option volatility, and the out-of-the-money puts were even more overvalued.

On the other hand, at the end of 1996, soybeans were trading at their lowest implied volatility in one year, at about 50% under its average historical level. This combined with the bullish fundamentals (lowest carry-over stocks in 20 years), indicated long term call option purchases. Soybeans are then followed by cocoa, sugar, corn and silver as option markets with comparatively low current option volatility to historical volatility, while the oil complex, S&P 500, copper and bonds are near the top of the list for high current option volatility markets- (These are markets that indicate option sales).

The above chart is an OPTION VOLATILITY COMPOSITE that can be used to track option volatility levels and volatility trends.

Another item to track is the statistical volatility, which is the current volatility of the futures contract compared to past readings. For example, the Deutsche Mark and Japanese Yen are trading at about 50% their normal statistical volatility levels, while the Swiss Franc is at about 40% of its normal levels, followed by gold, silver and cocoa. On the high side, this statistical volatility in copper is 60% higher than its historical norm.

The four volatility charts [below] provide examples of how we use volatility in determining our trading strategies. The first two charts are the S&P 500 and crude oil. Their high relative volatility dictates what to look for in Ratio Spreads to take advantage of the very high premium for the out-of-the-money options. Treasury bonds still have relatively high volatility (7) and a choppy trading range technical market pattern; Neutral Option Positions are best in this environment. Chart 4 shows the low volatility in the sugar market which signals consideration of option purchasing strategies.

Chart 1

Chart 2

Chart 3

Chart 4

Putting It All Together

We use the following rules:

1. The most important measure of overvaluation is the current implied volatility compared to readings in the past.
2. Also important is "premium disparity" between the individual strike prices to determine whether options other than the close-to-the-money options are experiencing further over or undervaluation.
3. If a markets statistical (futures) volatility is very low and its option volatility is also very low, be very cautious in selling options because of the likelihood of a move back to the norm on both of these guidelines towards higher futures and options volatility.
4. The best of all worlds would be very high option volatility compared to statistical volatility. This would mean that options are very high priced even though the futures are not moving.

David L. Caplan is president of Opportunities in Options located in Oxnard, CA. His latest research work is entitled Trade Like A Bookie. For information on his services or a free sample of his "Bookie" newsletter, call (800) 456-9699. There is risk of loss in all trading. Past performance does not guarantee future results.