How To Determine Whether A Stock Option Is Over Or Under Valued

Today's options markets are very efficient and options tend to be "fairly priced" at all times.  As such, options are rarely, if ever, over or under priced. 

Option are, from time to time, relatively expensive or inexpensive.  However, just because an option is expensive does not mean that it is "over priced" as there may be a very good reason why the option price has increased.  Conversely, there may also be very good reason why an option is relatively inexpensive.

As the market becomes more concerned about future price movement, there is a willingness to pay more for options to protect equity positions or to take advantage of anticipated price movement.  Once those concerns pass, option prices will likely fall to lower levels.

This whole discussion boils down to a study of implied volatility and how it can be used to assess current option prices.  An option is only "cheap" or "under priced" if you expect implied volatility to increase.  Conversely, an option is only "expensive" or "over priced" if you expect implied volatility to fall.

You can quickly determine the current implied volatility for any option through any decent options broker.  Once you know what the current implied volatility is for an option, you can then compare it to where implied volatilities have been in the past.  You can also compare current implied volatility to the historic volatility of the underlying security.

When comparing current implied volatility to where implied volatility has been in the past, you are looking at the changing market expectations for the future volatility of the underlying security.  As IV rises, it reflects greater uncertainty and concern in the market for the future price movement of the underlying stock. 

For example, you might see IV rise as a key earnings date approaches followed by a return to prior levels once the news breaks.  That news may be the catalyst for a large price move, up or down, or it may unfold as a non-event despite the heightened uncertainty that preceded it.

A comparison of implied volatility to the historical volatility of the underlying security allows you to assess whether the market's expectations are consistent with what the stock or index has done in the past.  As we have all read in any prospectus or financial disclaimer, past performance is not an indication of future results. 

So, if you see IV rising or falling relative to historic volatility, it does not mean that the option is "over" or "under" priced.  Rather, it should prompt you to question why the market is pricing in a greater or lesser amount of future volatility.  Once you identify the catalyst for the IV change, you can then determine whether you want to be long or short vega. 

Numerous services are available for assisting you in the analysis of option prices.  Personal preference and our budget play a large role in selecting which tool is appropriate for your needs.  The key aspect of this analysis is to determine whether you prefer being a net buyer or seller of options based upon where you think implied volatility is headed.