Value Trading
I am often asked questions like: “Should I buy out-of-the-money options or in-the-money options?” “What do you think of vertical spreads?” Or, “Do you think iron butterflies are good spreads?” There is no general correct answer to these questions, as the answer depends upon the prices.
The general principle that should guide your option purchases and sales is to buy underpriced and sell overpriced. Of course, you must have a way of determining which options are overpriced and which are underpriced. One choice is to use a standard model, which is the choice we employ on this site. There are certainly other valid methods of deciding value, but our choice is a particularly natural one that is in widespread use.
When you buy a calendar spread like one in GUC today (long one Oct. 80 call and short one May 80 call), you see that the cost of the long at the close today was $7.75 and the value was (at the historical volatility) $13.99, whereas the sale of the short would bring in a premium of $4.25 and the theoretical value of the May 80 call is $6.55.
Buying the Oct. 80 gives you an expected profit of $6.24 ($13.99 – $7.75), but when you sell the May 80 call you are selling an option which is underpriced, so selling the May 80 gives you an expected loss of $2.30. But your net expected gain is $6.24 – $2.30 = $3.94, so the calendar spread is on balance a good bet.
You may not always be able to both buy underpriced options and hedge them with overpriced options on the same underlying.
In fact, this can be done only rarely. You usually have to give up some value in order to build a protected position, and the value you give up is the cost of that protection. But you should make certain the net expected gain is positive–buy more value than you give up on the sell side, or sell more value than you give up on the buy side.