If you trade options, price is paramount. An overpriced option, like an overpriced stock, can adjust downward without warning, reducing or eliminating possibilities for resale. Even if it doesn't adjust, paying too much for an option contract will reduce any profit you receive, whether you sell the option itself or trade the underlying security.
Call Option Basics
A call option is a contract that gives the holder the right -- but not the obligation -- to buy a security at a certain "strike" price. All options have an expiration date. American options may be exercised (activated) at any time before their expiration dates, while European options are exercised on the expiration only. If you sell a call option, it's known as "writing" the call, and you are obligated to sell shares if the holder chooses to exercise the option.
Call option prices are affected by several elements: the price of the underlying security, the time until the expiration date, the current interest rate and the implied volatility. The relationship between these elements is described through the Black-Scholes equation, which also serves to define the implied volatility -- the one element of an option price that is determined solely by supply and demand. Implied volatility is the market estimate of how much and how often the call price will fluctuate over time. In general, traders believe that if the call's implied volatility is significantly greater than its actual historical volatility, the call is overpriced.
In general, call options in a bull, or upward moving, market tend to be somewhat overpriced. This does not mean you cannot take advantage of them, only that you need to pay attention. One popular strategy is to sell the overpriced call and buy one that is priced more fairly. The premium you receive to write the overpriced call offsets the cost of the lower priced call. If the call you write is assigned, you can use the lower priced call to purchase shares and still make a profit. This is known as a bull call spread. It's also possible to use an overpriced call in a more traditional sense if you believe the price of the underlying stock will continue to rise. You can sell the call as is, or use it to buy shares.
Implied volatility is just that -- implied. Historical evidence shows that a call's actual volatility rarely follows its implied volatility. When trading options, it's important to consider all factors -- implied volatility, underlying stock price and behavior, economic and company news -- before placing a trade. Have an exit strategy in mind and practice caution, as option prices change rapidly.
Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.