Is there a point where option premiums are too high? And if so, does that make you a buyer or seller? An interesting debate where, surprisingly, the right answer may be counter intuitive.

You would think if option premiums are high, option writing strategies make sense, which as a general rule is true.

When premiums are high, covered call writing or cash secured puts usually makes more sense that going long calls or long stock plus a put. Simply because, in general terms, the cost of the option is too high for the benefit you get.

The logic of writing options when premiums are high certainly holds when dealing with options on indexes and for that matter, sectors. I’m not sure it makes sense when dealing with individual stocks.

What brought this to light for me, was a review of some April 470 calls that I was short as part of a covered call write on Google. I looked at the options yesterday, with the thought of closing them out prior to expiry. But, with Google trading at US$449.54, the Google April 470 calls were trading at US$6.20 per share. These were out of the money calls that would cease trading 24 hours later.

Just how expensive were these calls? How about 105% implied volatility! For comparison purposes, the Google May 170 calls were trading with an implied volatility of 46%, closing to the norm for Google options.

The issue of course was Google’s earnings, which were slated to be released after the close of trading Thursday night. Google blew away the earnings number, and as you might expect, the stock surged in after hours trading to US$526.20. The Google May 470 calls were now worth US$56 per share, for a net gain of 800%.

A high risk trade to be sure. But on a stock that has historically never provided guidance, the returns were, perhaps, to be expected?

What the Google example tells us, is that there are times when options are simply too expensive. Too expensive to write that is!

Option traders would be well served to live by a rule that says; when options are trading at irrational prices, it is often, not irrational.

In fact, when companies are reporting earnings just before an option expiry, and when we see implied volatilities in excess of 100%, it is telling us that traders expect the underlying stock to make a significant move… up or down. Most often, they are right. And in cases like that, speculators need to be aware.

We all missed this one, but there will be others. Around the release of quarterly earnings. Particularly on stocks where there is a wide range of estimates among analysts. And where the near month options are trading at +100% implied volatilities.

We will keep an eye on this going forward, and provide some examples as we get near the May and June expiration. Stay tuned!