Option buyers prefer buying cheap options. Why would an option be cheap, anyway?
Cheap options could be cheap for any number of reasons. Perhaps they're far out of the money, or they're only slightly out of the money but there's little time left until expiration. These options may have low actual costs, but they may also have low absolute values for their deltas. Delta is the Greek that predicts how much an option's price may change if the price changes one point.
Day or swing traders who buy such options are speculating that a big price move is imminent. With a low absolute value for its delta, the price of one of these options isn't going to change much with each one-point move in the underlying. A big move is needed to change their prices and overcome the commissions incurred in the trade.
These options may be cheap, but, unless that big move is anticipated, they may not be the best bet for a day or swing trader who wants to buy long puts or calls. I've often gotten questions from subscribers who write questions that say something such as "The OEX moved three points, but my OEX option's price barely changed." After investigating, I'll often find that the delta of the call they bought was near 0.05 (or 5, if your quote source applies the 100 multiplier before listing the Greeks). A three-point rise in the OEX would be expected to change the option's price only .15, and if volatilities dropped while the OEX was climbing, the increase might have been less than that. By the time those traders split the OEX's wide bid/ask spread on buy and sell trades and pay commissions, that small increase might not have been enough to produce a profit on the trade.
Far-out-of-the-money options might be tricky for day or swing trading, but they are often used for hedging purposes. Traders who trade complex or combination options trades such as credit spreads, iron condors, butterflies and double diagonals employ those cheap options to either hedge or insure their trades.
Options may be cheap for other reasons. Perhaps the underlying is a staid security that typically moves very little. Some traders employ such options for trades such as calendars. Some option traders search for options that are cheap for a far different reason than those listed here: options that are cheap because their implied volatilities are lower than historical volatility. Such traders are essentially betting on a volatility move, not necessarily a price move.
Newbies may require an explanation of the two types of volatility before reading further, while experienced traders can skip this paragraph. A Friday, April 24 Options 101 article, "Volatility on the Brain," described the two types of volatility in depth. Historical volatility relates to how much the underlying security's price moves over a specific period of time. It's a measurement of the actual historical movements recorded over the period of time being studied. Implied volatility is more of a spot measurement of the anticipated volatility of the underlying between the current time and expiration. Implied volatility may be higher or lower than historical volatility.
Option pricing calculators require implied volatility as one of the inputs. Higher implied volatility raises option prices, and lower volatility depresses those prices. Some people expect lower-than-normal volatilities to eventually revert to their normal levels, expressed by historical volatilities. Therefore, if implied volatilities are below historical volatilities, they think there's a chance that the implied volatilities will climb toward that historical norm. In the absence of other forces, the option's price should rise when implied volatilities revert to the norm as expressed by that historical volatility. Hence, for the time being, until that happens, the option is considered cheap.
Some option traders compare the two volatilities to find cheap options. How do they do that? They look for options in which the implied volatility is much less than the historical volatility, or specifically when the IV/HV ratio is low. They want to find options in which the implied volatility might be expected to revert to that historical norm.
Many brokerages offer scans that look for stocks or other underlyings with low IV/HV ratios. If your brokerage doesn't offer such scans, the CBOE does, offering several variations. The CBOE's preset scans even include short-term and long-term predictions of increasing or decreasing implied volatilities. I haven't previously used these CBOE scans and can't vouch for their ability to predict volatility movements.
A couple of weeks ago, however, JNJ's stock was identified by a CBOE scan as one in which the options had low implied volatilities when compared to historical volatilities. That scan would suggest that its options were cheap at the time relative to their typical or historical volatility over the period covered. I note that, soon after that scan, JNJ topped and started a downward move that lasted at least several days. Implied volatilities tend to rise when during a downward move, particularly if the move is sharp. A glance at a volatility chart does show a slight upward tick in the implied volatilities as JNJ started heading lower.
Some traders may use such scans when looking for opportunities for strategies such as outright call or put purchases or complex orders such as long straddles or strangles. Typically, a trader would want to avoid strategies that involve selling the underpriced options. For example, a calendar trader wouldn't ordinarily want to sell an underpriced front-month option unless that trader had a special reason for doing so.
However, before a trader chooses a cheap option based on a scan, some questions must be asked. The trader is betting on price moving as desired but also places a bet that volatility will revert to the historical mean and will do so before that option expires. What if implied volatilities have dropped in comparison to historical volatilities over a studied period because that studied period included a time when volatilities suddenly shot higher, skewing the historical volatility measurement? What if the underlying has, since that time, been chugging slowly upward, pulling back to a rising 10-sma, and then chugging slowly upward again? Implied volatilities are likely to be dropping under such conditions, especially compared to that abnormally high historical volatility.
If the underlying continues climbing in that steady manner, those implied volatilities are likely to continue dropping. Unless some important historical resistance level is closely approached, earnings are impending or some important announcement is upcoming, the implied volatilities are not likely to revert to the historical volatility's level as the underlying continues a placid climb. A long call buyer may find that the call drops in value or doesn't gain, even as the underlying chugs slowly upward. Time and the continued drop in volatility are going to work at cross purposes with the slow gain in price.
Does any of this sound a bit familiar in the climate seen as many securities climbed higher into the 8/7 market highs? If we're using historical volatilities computed over a year's time as our norm against which we're comparing implied volatilities, our view may be a bit skewed. During this last year, volatility levels climbed to record levels in some cases.
Running such scans and choosing supposedly cheap options on unfamiliar securities as a result of that scan can result in a tricky trade. Traders must remember that options that are cheap relative to historical norms can get cheaper, just as expensive options can grow more expensive. The trader who is choosing options trades based only on such scans often skips from security to security, without a lot of understanding of how and why that security might be moving as it is. I remember, for example, when I first began trading, I honed in on Enron's stock as my vehicle of choice. (Dates me, doesn't it?) While still a newbie, I started noticing that about mid-morning about once or twice a week, Enron's stock suddenly made a big move. Turns out that odd movement was probably occurring when oil or gas inventories were being released, but I didn't know enough about the stock's behavior at the time to connect that behavior with those releases. I just don't recommend jumping from security to security in this manner.
In fact, the Options Industry Council, an educational site for options traders, counsels that scanning for and then buying cheap options or selling expensive ones "may not be practical for the typical trader." The Council points out the very concern I've mentioned, that cheap options may get cheaper, adding that may happen because "there may be a reason that the market is pricing the option more inexpensively than in the past."
If you're considering scanning for cheap options, when "cheap" is measured by comparing implied versus historical volatilities, and then employing strategies that go long those options, talk first with your broker. Consider running such options trades through a trade simulator or paper money account for a few options cycles rather than trading them live. Understand that you'll need an opinion about where volatilities may go as well as an opinion about what will happen to price in what time frame.