When valuing options, a lot depends on the underlying stock the option represents.  After you get past comparing the strike price to the current share price and evaluating how long the option has until expiration, the rest is how likely you think the price of the underlying stock is to show enough movement to make the option profitable for you.

When it comes to analyzing stocks for volatility (how likely the price is to change and by how much) there are two methods you can use.  One is more applicable when it comes to investing in options contracts but both are important to understand.

Fundamental Analysis
Fundamental analysis involves the actual underlying value of the stock in question.  Things like price to earnings ratio, market capitalization, balance sheets, book value, competition in their market, and a wide variety of other statistics that indicate the overall health of a company.  While these factors are important they don’t tend to move the stock price enough in the short term to merit much consideration when pricing options.

Technical Analysis
Technical analysis concentrates on short term price movements in a stock.  It’s more concerned with trading volume, pricing patterns on stock charts, and various chart formations that have historically indicated gains or losses in stock prices in general and the stock represented by the option in particular.

Technical analysts believe that the most important factor in price movements is the actual trading activity in the stock and what it says about investor’s perception of that stock and the likelihood that they’ll sell at various price points.

For example, many investors will hold onto a stock that has fallen significantly until it returns to the price at which they originally bought.  This psychological tendency means that heavy trading volume at a particular price point for a stock whose price has since fallen will encounter “resistance” as it’s climbing back up and past that price.  Investors who originally bought there are more likely to now sell there which would act as downward pressure on the stock slowing its ascent.

So, a technical analyst would value an option with a strike price below this resistance level as more likely to profit vs. one with a stock price only a dollar or two higher but on the other side of the resistance level.

Because technical analysis is focused on factors that impact shorter term price movements than fundamental analysis it tends to be used more by traders when evaluating option contracts.  But, using a combination of both types of analysis along with understanding market trends and calendar events like earnings announcements will give you the most well rounded research possible.

But, you’re not required to take any particular analytical approach with options trading.  In fact, you’re not required to do any research at all.  But, if you want to be in the market for more than a few trades, understanding fundamental vs. technical analysis will serve you well.