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When Cheap Options Aren't a Bargain


Tracking how time and supply suppress premium.

Cheap, out-of-the-money options are sometimes referred to as lottery tickets because of the long odds but potential high payoff that comes with their purchase. With options set to expire today, there are plenty of people that are clinging to some OTM options hoping for a big move that will deliver profit before the end of the day. Therefore, an anecdote from this morning's subway ride seems like an appropriate analogy for discussing some option concepts.

It involves a man who, through some prior and, I'm sure, totally legitimate transaction, was in possession of several hundred "scratch and win" lottery tickets. The face value of these was pegged at $1 each, and the payoffs ranged from a maximum loss of the initial cost up to a $10,000 jackpot.

The two main differences between these lottery tickets and a call option are: The former has the probability of being a winner printed right on the back and there's no time limit. The latter does offer some hint at the odds through the implied volatility or price of the options, and they come with a definitive expiration day.

Apparently, this enterprising man fancied himself a market-maker and thought that the state of New York had awarded too high an implied volatility, making the tickets too expensive based on the odds of winning. He didn't want to waste time scratching his tickets; instead he was willing to sell them. He priced them at seven tickets for $5, around $0.70; or 20 tickets for $10, or $0.50 each; or a full 50% discount to face value.

As imperfect as it may be, this example illustrates the fact that when someone owns a huge inventory of something, especially at a low-cost basis, it can cause a sharp decline in implied volatility levels. That's reflected in the option's price if it's placed on the market for sale.

A somewhat recent example of this occurred when JPMorgan (JPM) worked with Microsoft (MSFT) to buy hundreds of millions of dollars of underwater employee options. This created a huge overhang of options held by the bank, which then needed to sell or sell stock to recoup its cost. That was one of the factors contributing to the decline in volatility in Microsoft's shares and the IV of its options.

Low Price Doesn't Equal a Bargain

From the buyer's side, where most of us operate, it was interesting to see on the subway that people who normally don't play the lottery, myself included, were suddenly willing to fork over $5 or $10 for a shot at winning.

Though the percentage return on a winner certainly increased, the odds of making money hadn't changed at all. However, the perception was that these tickets were cheap and represented a "bargain."

There's a price point at which the lottery tickets do become good value. After all, there will be a few winning tickets in each hundred, and stocks have their historical volatility and tendency to revert to the mean -- which allows one to make a case that an options IV is "relatively" cheap or expensive.

But it's important to keep in mind that simply because something is priced lower than it had been recently, it may not represent a good value.

And apparently the lottery market-maker had his own expiration date. As we reached the final stop at South Ferry, he offered the tickets at $10 for $1. He quickly sold out the remaining tickets.

But remember as the saying goes, that light at the end of the tunnel just might be headlights from the expiration express. Sometimes its best not to be standing on the tracks with a handful of options -- no matter how inexpensive they were.
No positions in stocks mentioned.

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