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How to Trade Mispriced Options

Do you like trading options but don’t have access to an option pricing model? Do bids and asks on equity options occasionally make little sense to you?

Even if you know the Black-Scholes option pricing model, it can be an arduous task to price an option. Furthermore, you may not have the most up-to-date standard deviation to put into the formula.

Well, if this rings a bell, you’re not alone.

This frustrating phenomenon is far from uncommon, particularly if you’re trading online through a discount brokerage or even via the website of a full service brokerage house or bank.

Don’t Blame Your Broker

With that said, mispriced options are likely not the fault of your broker or the brokerage house he or she works for.

It’s unlikely they’re trying to pull a fast one on you, as the market is highly regulated. Rather, these odd prices are largely due to the fact that some equity options are just plain illiquid.

Here’s the issue: If the underlying equity is illiquid, then there’s a high probability that options on that stock are going to be even more illiquid.

Even options on many liquid stocks don’t trade very often. Of course, there are always exceptions, but it’s still a good rule of thumb to trade by.

Take Piedmont Natural Gas Co. Inc. (PNY), for example. It’s trading at $57.56 as of this writing. Now let’s go to PNY’s option chain, listed on the website of a prominent brokerage house:

Piedmont Natural Gas Co. (PNY) November Options Chain

As you can see above, there are lists of puts and calls, with the expiration date of November 20, 2015 used as an example. As the strike price of the call increases for any specific expiration, the price of the option should decrease, and the opposite should occur with put options.

While these price increases and decreases aren’t always linear, there should be some consistency.

Yet the consistency breaks down with this particular stock, as the highlighted bids and asks above reveal. It appears that the options are mistakenly mispriced or else there’s little logic to how these options are priced.

Alternately, you may think that you’ve found some unique inefficiency in the market that has escaped the eyes of every other trader and that you should jump on it. Thus, you go ahead and place what you believe is an aggressive bid or offer.

So let’s say you act on your supposed newfound information by placing a bid on the $55 November put option at $0.10, which is the offer price listed.

After all, shouldn’t the offer be around halfway between the $50 strike offer of $0.60 and the $60 strike offer of $5? Comparatively, $0.10 seems like a great price.

Thus you end up getting filled on your bid at the ask price of $0.10 and you should feel pretty good, right?

But what has likely happened is that the stock, being thinly traded, is in the hands of one financial firm representing the market maker. And when there’s no bid or offer for an option, the market maker is free to set any price for it.

Even if the price of the underlying stock moves, the market maker may not update the options prices for days until an actual bid or offer hits the market.

Furthermore, the market maker will usually have the stock in its inventory, so it’s a lot easier for the firm to trade in and out of options and their underlying stock, as well as to set the options’ price, than it is for you.

What Is the Real Value of an Option?

When trying to determine the value of an option, two indicators – volume and open interest – together offer a good starting point.

Note that there’s been no volume on any of these puts for this particular day so far, and that there isn’t a meaningful amount of open interest across the board either. This is an immediate red flag.

Also, look at the order book for the options, which will give you a good idea of how liquid they are.

Additionally, some websites will indicate when the last trade took place so that you can determine how up to date the price actually is.

The price of $0.10 may have been from days ago. And if you choose another strike with no open interest, it may just be a price the market maker has posted.

A better strategy would be to figure out just what the value of this option actually is, prior to placing your bid.

As mentioned before, you can price it on your own with the information you have… but an easier approach is to go to the Chicago Board Options Exchange (CBOE) website.

Under “Trading Tools,” chose “Options Calculator” and put in the ticker of the underlying stock. Then choose your strike and the program will calculate the option’s value along with all of its Greeks.

In doing so, the site reveals that the value of the put option that you paid $0.10 for is really only worth $0.0014 – far less than a penny!

The bottom line is that you should follow the steps above if you want to be more accurate in your options trading.

Keep in mind that, even as a small retail trader, you can disrupt the market by placing a bid or ask that’s closer to what you believe is a fair price. Others may have already done so, which could’ve caused the price disparity in the first place!

Even if you’re buying or selling just one option, the system must take your price into account and post it so long as your price is higher than the current bid or lower than the current offer.

The next time you think you’ve discovered some acute inefficiency in the marketplace, look at volume, open interest, the order book, and the date and time of the last trade. Most importantly, get an idea of the option’s value before you place your bid or ask.

Good investing,

Shelley Goldberg

Shelley Goldberg

, Senior Correspondent

View More By Shelley Goldberg