How to Choose Between Cheap and Expensive Options - Yahoo Finance

While option prices are based off stock prices, option and stock trading are two very different things. A buy and hold long-term investor does not have to worry about volatility. Option traders, on the other hand, need to be mindful of expiration dates, making volatility key. Option prices consist not only of intrinsic value, but also of time value. The time value varies from stock to stock, but it determines the implied volatility. The stock move must overcome this time value for the option to make a profit, and the move must occur before the expiration date. 

Established large-cap companies typically have cheap options, while smaller, more speculative companies generally have expensive options. The example below clarifies that point. There is more certainty in the fundamental performance of Coca-Cola (KO) than Live Nation Entertainment (LYV), so KO will have cheaper options. These two stocks, as of mid-day yesterday, were essentially the same price, right around the $46 mark. The table below compares the 45-strike call option that expires on 7/17/2020 for each stock. The implied volatility on the LYV call option is two and a half times the implied volatility on the KO call option. Thus, for the KO call option to breakeven, the stock only needs to increase by about 2% before the expiration date. For LYV, however, the required stock move is more than three times that amount, at 6.4%.

Why would anyone choose a LYV call option over a KO call option? For one, the higher implied volatility means LYV is expected to trade in a much wider range than KO. In other words, there is a higher probability of a big stock move in LYV. 

That is the trade-off option players make. They can buy a low-priced option that profits handsomely on a relatively small move by the stock, or they can buy a high-priced option on a stock that needs to make a sizable move, but the potential for that sizable move is greater. In the analysis below, I show the challenges that high implied volatilities present option traders to see if one of those trade-offs has worked out better over the past year.

Stock Trading vs. Option Trading

The table below perfectly sums up the difference between option trading and stock trading. It also shows the massive effect of option prices on option returns.

Since we are 16 trading days from the regular July monthly expiration date (7/17/2020), I looked at stock and option returns for 16-day periods before other expiration dates. In the June expiration cycle, the S&P 500 Index (SPX) gained 2.2% in the 16 days before expiration. This was like the market return in the 16 trading days before the December expiration, in which the S&P 500 gained 2.4%. The trading environment, however, was completely different. In December 2019, markets were relatively calm and had been steadily climbing for a few months. More recently, the S&P 500 is coming off one of its worst, then best short-term performances ever. Option prices, therefore, have been much more expensive.

Finally, we can take a look at these numbers. I am comparing the returns of at-the-money call options of S&P 500 stocks in the 16 days before expiration. The options were a lot cheaper in December of 2019, with the stocks having an average implied volatility of 22%. In June, the implied volatilities nearly doubled, averaging 43%. Holding the stocks, a trader would have gained about 2.08% in December and 2.44% in June. For stock traders, there wasn’t much of a difference between these time frames. Now, look at the average return on the call options. The average call option would have gained 21% on that 2% gain in December of 2019. This demonstrates the leverage you can gain using options. Then in June, with a similar stock return, the call options lost an average of 21%.

In other words, doubling of the implied volatilities was extremely damaging for the option returns. Nearly half of the call options would have been profitable in December of 2019, but only around 30% were profitable this past June. Similarly, over a quarter of the call options would have gained 100% or more in the low-volatility environment of last December, but only 13% would have doubled in June with more expensive options. 

Cheap or Expensive Options: Which Have Been Better?

I mentioned the trade-off between cheap and expensive options earlier. Cheap options require less of a move from the underlying stock to get a positive return when compared to more expensive options. The more expensive options, however, are on stocks expected to make bigger moves. The table below compares cheap options to expensive options over the past two expiration cycles (again, 16 trading days before the expiration date).

I broke the returns down into four brackets, based on the option’s implied volatility. The first row summarizes the returns for the stocks with cheap options, with an implied volatility that averaged 30%. The bottom row shows the most expensive options, which averaged an implied volatility of 79%. The group of stocks with expensive options had the best stock return, averaging a gain of 3.9%, while the stocks in the least expensive option group gained just about a half of a percent. Since the market has gone up over these time periods, you would expect the expensive options to have better returns.

The past couple of months have created a tough trading environment for options, as we can see with the average return losses of over 20% for each bracket. The expensive options, however, lost the least amount per trade. The at-the-money call options on those stocks lost an average of about 23%, while the other brackets lost on average close to 30% per trade. The median return for the cheap options is -100%, meaning that on more than half of the trades, traders would have lost their entire option premium. One last observation is that only 10% of the expensive options would have had a 100% return -- the lowest double-rate of all the brackets. The cheapest options saw about 12% of the options double, and the options with moderate implied volatilities doubled at a rate of just over 14%.

With 20% losses in each bracket, it is hard to endorse one strategy over the other. What is clear, however, is that it has been a difficult trading environment for option traders, so discipline and due diligence is of the essence.

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How to Choose Between Cheap and Expensive Options - Yahoo Finance
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