The Morningstar Option Strategy Map

Investing in stocks is both a complex and a simple exercise. The complex part is figuring out what a stock is worth. The easy part is comparing that fair value with the price Mr. Market is serving up, and then investing accordingly. If the two prices match, you do nothing. If Mr. Market is offering the shares on the cheap, it's time to buy. On the other hand, if Mr. Market is really crazy and has priced the shares at twice their worth, maybe you consider selling him the shares, expecting to buy them back once he comes to his senses.

Investing in options is a bit more complicated, but all of the complexity really boils down to a basic framework. I'll explain that framework now, and I'll work through the complexities in later articles.

The key difference between stock investing and option investing is the addition of a second dimension that is needed to put a price on an option, and that second dimension is uncertainty about the price of the stock in the future. Uncertainty is commonly measured in implied volatility, which I'll discuss in careful detail in later articles. For this discussion, it's enough to know that implied volatility is the unit of measure for uncertainty. Both the stock price and the uncertainty are set by Mr. Market, and these two inputs combine to determine the price of an option.

We can approach the uncertainty dimension for options like we approach the price dimension of stocks: Figure out a value for the uncertainty, and compare it with the price the market is actually charging for it. Just like the objective of stock investing is to buy undervalued stocks and sell overvalued stocks, the objective of options investing is to buy undervalued uncertainty and sell overvalued uncertainty. So, an implied volatility that is too low means we want to buy the options and an implied volatility that is too high means we want to sell the options.

The Morningstar Option Strategy Map
We can summarize our three potential conclusions about underlying stock as follows:

• Overvalued Stock: Bearish
• Fairly Valued Stock: Neutral
• Undervalued Stock: Bullish

Similarly, we can summarize our three potential conclusions about the uncertainty:

• Overvalued Uncertainty: Sell Options
• Fairly Valued Uncertainty: Neutral
• Undervalued Uncertainty: Buy Options

If we put the stock valuation dimension on the vertical side of a table and the option volatility valuation dimension on the horizontal side, we can fill in the grid with the potential option investment strategies, creating the Morningstar Option Strategy Map:

There are more complexities to options investing, but the valuation of the stock and the valuation of volatility are the big hitters that should get you started on fundamental investing in options. How does one value uncertainty? I'll admit it's not simple, and I'm working with our stock analysts to more fully align Morningstar's risk rating with uncertainty about the fair value, and to quantify that risk rating. However, you can think of Morningstar's risk rating as a very rough guideline for the long-term valuation of uncertainty.

Other Dimensions
Just for completeness' sake, there are two other dimensions to consider in options investing, the timing dimension and the strike/stock dimension. The timing dimension is introduced by the different expirations of options creating the potential for implied volatility to vary across duration, and the strike/stock dimension is introduced by the different strike prices allowing implied volatility to vary across strike prices as well. These dimensions can have an impact on any options investment, and they open up the potential for the volatility structure trades discussed in the middle box of the Option Strategy Map. However, logical fundamental investing and risk tolerance often provide guidance on what duration or what strike to choose for a fundamental investment.

This little three-by-three table may not capture every nuance of option investing, but as a way to structure your thinking, it's a pretty good start. To investigate the implied volatility of options on stocks you may be considering, try Morningstar's new options chains, accessed through the Options tab on Morningstar.com.