Editor’s note: Park Research LLC @ParkResearch is a relative newcomer to the CBOE Options Hub family.
“Gilead Sciences Inc. (GILD) has 12 products in the Phase II trials and 7 products in the Phase III trials. Everything about the company’s fundamentals can change in a single day when the FDA makes a definitive decision on a late stage drug trial.” (http://www.cmlviz.com/cmld3b/lite.php?app=rc&ticker=GILD)
As option traders, we constantly look for options that are underpriced and overpriced. We will use the Park Research, LLC’s proprietary model that utilizes historical information. As of today (August 17th), $GILD closed at $116.42. Naturally, we look for options that are the closest to the underlying to determine whether options are overpriced or underpriced. We would like to use options that are 30 days or less. In this particular case, we looked at 11-Sept-15 expiry.
As you can see above, the 116/117 strangle are priced at $4.83 (ask). Using the historical information, the model “forecasts” that the strangle has a 63% chance of break-even. Using the same information, the model calculates that the fair price of the strangle is approximately $5.95, 23% higher than the current ask price of $4.83.
As you can see above, the implied volatility is relatively cheap (IV percentile and IV Rank). However HV21 is still greater than HV10 and HV10 is greater than HV5. It’s also true for ATR21, ATR10, and ATR5 as well as PRCBB True Range (PRCBBTR) 21, 10, and 5. Therefore, it’s not necessarily a perfect condition to buy a straddle or strangle even if the option is underpriced.
We would also like to dive more into the PRCBB TR%; more specifically compare it to the straddle/strangle %. The current strangle 116/117 is priced for 4.16%. The PRCBB True Range % is the difference between high and low, and divide the difference by the underlying price. The lowest true range in the last 52 weeks is 4.88% while the median and average true ranges are 10.21% and 11.14% respectively for 18 trading days. This tells us that the straddle is definitely underpriced.
Finally, we want to take a look at the Implied Volatility Expected Move vs. Statistical Expected Move vs. Historical Probability Move.
The implied volatility expected move is the green colored line while the statistical expected move is the red colored line. The historical probability move is the histogram bars. Both the statistical expected move and historical probability move have greater ranges than the implied volatility expected move.
In the end, you have to make the decision about the option price. If you think the stock will be outside this range ($4.83), then you believe the option market is underpricing risk (options are too cheap). If you believe the stock will be inside this range, then you think the option market is overpricing risk (options are expensive). IF the range seems “about” right, then you agree with the option market pricing.