Options Valuation for Beginners

Investing using options is very different from constructing a classic long-term buy-and-hold portfolio.

In this segment from Motley Fool Live that first aired June 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss the easiest way for beginning options investors to understand their valuation.

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Ellen Bowman: Jenny asks, can you suggest some good options evaluation tools and calculators, sectors that are particularly good or bad? Before I let you talk, I’m going to say for anybody listening who’s new to options, go to the Chicago Board of Exchange, CBOE, they have an options simulation tool where everything’s real but the money. You can run the strategies and the simulations, and you can see what would happen to you without risking a dollar. So anybody looking for places to start poking around with options, I use that process and it was certainly edifying for me. So hopefully, it will be for you too. What else would you suggest, Jim?

Jim Gillies: I’m going to say something sacrilegious I think.

Bowman: Go. They’ll bleep you. They’ll bleep you if it’s too bad.

Gillies: Probably. First of, option valuations don’t matter.

Bowman: The valuation of the options itself.

Gillies: Does not matter. If you start with the first principle, which is valuation first, that’s referring to valuation of the company and then options, second. I know all I need to know about an option strategy if I’ve done the valuation work. Option prices are very mechanically set. You’ve probably heard of the Black-Scholes option pricing model. There is a less well-known binomial style model. But these things all have inputs that are all readily obtainable and observable. There’s 5, 6 depending on your point of view. Inputs, stock price, which we know, strike price, which we know; time to expiration, which we know; risk-free rate, which we can get from interest rates, which is available [inaudible] quotes which so in other words, we know if a accompany pays a dividend, that’s the one that’s wonky. That inputs, the stock price a little bit, but you bring that to our fifth one in. Of the six inputs, I’ve just given you five, and those are all easily obtainable, directly observable. The sixth one is called implied volatility, and that’s the volatility that the option price is baking in. Volatility is ups and downs between now and expiration. The implied volatility is what the option price, which you can also go look up and then stick into an excel model and back out for the implied volatility number or Cboe. We usually talk about it. Any of your brokers will tell you the implied volatility for options you’re using. But all you need to know there is high number, it’s measured in percentage points. A high number is fairly expensive. A low number is cheap. But of course, if you’re playing with options on a pretty stayed blue chip, you should expect volatility below, and if you’re playing with things that are going crazy, you should probably expect it to be high. Honestly, all you need to know is how to run the mechanics of options and again, Mueller can help you with that in the service. Understand the intrinsic value of an option, the time value of an option. What happens when the stock price goes up or down relative to the options. Very piecemeal. You don’t really need those fancy calculators. Honestly, probably all you need is Microsoft Excel and an understanding, that getting the understanding of how these things work is more important than finding tools online, in my opinion.

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