106 Part II: Call Option Strategies 
such an analysis for themselves, the details of computing a stock's volatility and pre­
dicting the call prices are provided in Chapter 28 on mathematical techniques. 
OVERPRICED OR UNDERPRICED CALLS 
Formulae exist that are capable of predicting what a call should be selling for, based 
on the relationship of the stock price and the striking price, the time remaining to 
expiration, and the volatility of the underlying stock. These are useful, for example, 
in performing the second step in the foregoing analysis, estimating the call price after 
an advance in the underlying stock. In reality, a call's actual price may deviate some­
what from the price computed by the formula. If the call is actually selling for more 
than the "fair" ( computed) price, the call is said to be overvalued. An undervalued 
call is one that is actually trading at a price that is less than the "fair" price. 
If the calls are truly overpriced, there may be a strategy that can help reduce 
their cost while still preserving upside profit potential. This strategy, however, 
requires the addition of a put spread to the call purchase, so it is beyond the scope 
of the subject matter at the current time. It is described in Chapter 23 on spreads 
combining calls and puts. 
Generally, the amount by which a call is overvalued or undervalued may be only 
a small fraction of a point, such as 10 or 20 cents. In theory, the call buyer who pur­
chases an undervalued call has gained a slight advantage in that the call should return 
to its "fair" value. However, in practice, this information is most useful only to mar­
ket-makers or firm traders who pay little or no commissions for trading options. The 
general public cannot benefit directly from the knowledge that such a small discrep­
ancy exists, because of commission costs. 
One should not base his call buying decisions merely on the fact that a call is 
underpriced. It is small solace to the call buyer to find that he bought a "cheap" call 
that subsequently declined in price. The method of ranking calls for purchase that 
has been described does, in fact, give some slight benefit to underpriced calls. 
However, under the recommended method of analysis, a call will not automatically 
appear as an attractive purchase just because it is slightly undervalued. 
TIME VALUE PREMIUM IS A MISNOMER 
This is a topic that will be mentioned several times throughout the book, most 
notably in conjunction with volatility trading. It is introduced here because even the 
inexperienced option trader must understand that the portion of an option's price 
that is not intrinsic value - the part that we routinely call "time value premium" - is 
really composed of much more than just time value. Yes, time will eventually wear