Desk Notes
The Spreadsheet That Stopped Me Buying Cheap Options
Four cells, ten seconds of arithmetic, and a result I did not want. The premium tells you the price. It does not tell you whether the option is expensive.
breakeven = strike + premium
That is the first cell. The second cell is implied move = (at the money call + at the money put) / spot. The third is the ratio of the first to the second. The fourth is a yes or a no, typed by hand. For about two years I would not have liked the answer.
Work it through on one position and you will see why.
One contract, carried all the way
Stock at $50. Fourteen days to expiration. The $52.50 call is offered at $0.45. That is the kind of number that stops feeling like a decision.
Breakeven at expiration is 52.50 + 0.45 = 52.95. As a move from here that is (52.95 - 50) / 50 = 5.9%. The stock has to rise almost six percent inside two weeks for me to get my money back, and further than that for the trade to have been worth the attention.
Now the second number. The at the money call is $1.40 and the at the money put is $1.35, so the straddle is $2.75, and 2.75 / 50 = 5.5%. That is the market’s rough estimate of how far this stock travels in either direction over the same fourteen days.
| What | Number |
|---|---|
| Move my call needs | 5.9% |
| Move the chain expects, either direction | 5.5% |
| Ratio | 1.07 |
I was paying for a scenario in which the stock delivers more than its entire expected move, in one nominated direction, inside a fixed window, and I needed that to happen more often than the pricing implied in order to be anything other than a donor. The ratio above one is the whole finding. Everything else in this post is me explaining why it took two years to run the division.
Why it felt cheap anyway
Two reasons, and neither of them is about the size of the loss.
The first is the shape of it. Maximum loss on a long call is the premium. Every position feels pre approved by somebody. Losing $45 on one contract is absorbed without noticing. Doing it twenty times over a quarter is 20 x 45 = 900, and the $900 arrives as a drip that never triggers the alarm a single $900 loss would.
The second is the occasional winner. It is spectacular in percentage terms, and percentages are what you remember. A call that goes from $0.45 to $1.80 is up three hundred percent. It takes up more room in your memory than eighteen contracts that expired worthless on a Friday afternoon while you were doing something else, which is the correct denominator and the one nobody carries around.
Both of those are accounting illusions. The spreadsheet has no memory and no sense of proportion. That is its entire value.
What I buy now, on the rarer occasions I buy
If I think the market is underpricing the move, I still buy the option. That is the only case where a long premium position has a defensible reason to exist, and it requires a view on the size of the move, which is a harder thing to have than a view on direction.
If I like the direction and the implied move already matches my forecast, a vertical spread lets me pay for the part of the distribution I believe in and sell the part I do not, and the payoff arithmetic for each of the four structures is in vertical spreads explained.
The sheet also taught me to respect the timing of implied volatility. Contracts into a scheduled event are expensive for a reason, and being right about direction while implied volatility collapses around you is one of the more instructive ways to lose on a correct call. That mechanism, with the earnings crush worked through, is in implied volatility explained.
If contract terms, moneyness and the split between intrinsic and extrinsic value are still new, start at options trading for beginners and come back to the division afterwards. To watch the premium respond to time and volatility as well as to the share price, the options Greeks calculator lets you move one input at a time.
Where I am genuinely unsure is the edge case. Sometimes the implied move is wrong and I have a specific reason to think so, and in those cases the cheap option is the correct instrument and the ratio test would talk me out of it. I cannot tell in advance which of those reasons are real. So I keep the four cells, I fill them in by hand before every ticket, and I accept that the test is occasionally costing me a trade I should have taken.
Frequently asked questions
Why are cheap out of the money options usually bad value?
A low premium reflects a low probability of the option finishing in the money, so the small dollar cost is a description of long odds rather than a discount. The contract is good value only if the move you expect is larger than the move already priced into it, which the premium itself will tell you.
How do I work out the move an option needs to break even?
For a long call the breakeven at expiration is the strike plus the premium paid, and for a long put it is the strike minus the premium. Divide the distance from the current price by the current price to express it as a percentage, then compare that with the expected move implied by the at the money options.
What is the implied move and where do I find it?
Add the price of the at the money call and the at the money put for the expiration you care about, and the total approximates the move the market expects between now and then in either direction. Dividing it by the share price turns it into a percentage you can compare with your own forecast.