Better Option Pricing and Trades

Better Option Pricing and Trades

Most investors don't understand option pricing. Implied volatility, historical volatility, intrinsic value, temporal value, and the "Greeks" (delta, vega, theta, gamma, rho...) are all concepts that they have trouble wrapping their heads around. These words seem scary, and from what I've seen, at least half the people you hear using them don't actually know what they mean. Knowing what you don't know and being intellectually honest about it are both essential. 

You should also correct your existing knowledge and debunk your vocabulary. It's nice to know you don't need to know much about the technical math soup, as it's easy to get a headache from trying to read and understand the plethora of equations and models generated by the minds of multi-degreed scholars speaking a language only they seem to understand. In order to avoid getting whipsawed and shredded by option prices, it is essential that you learn to detect them and flow with them.

It's analogous to the integration of engineering, manufacturing, physics, and computer technology into a contemporary automobile. If you give a ten-year-old the keys, he or she can drive off a cliff or down the road. The technical expertise to comprehend and build it is optional, but the skill to use it properly is essential.

Therefore, it is essential to learn about option pricing if you want to trade successfully. Importantly, option prices are not constant over time. Because of how the market and the market makers interact, the pricing structure is always changing.

The bottom line is the price. Models are laboratory creations that have no bearing on the market. They focus instead on making predictions about what will happen.

The concept of alternatives has been around for quite some time. Options were exchanged against outbound shipments in ancient Rome, Greece, and Phoenicia. The formal history of modern methods can be traced back to 1877.

The Theory of Options in Stocks and Shares was published in 1877 by Charles Castelli.

The first documented analytical valuation of options dates back to the year 1900 and is credited to Louis Bachelier. MIT professor Paul Samuelson took an interest in his work.

Samuelson wrote an unpublished paper in 1955 titled "Brownian Motion in the Stock Market."

"A Theory and Measurement of Stock Option Value" was published by A. James Boness in 1956. Fischer Black and Myron Scholes built on his earlier work.

Fischer Black and Myron Scholes developed a revolutionary methodology for valuing options in the years 1969–1973.

Each new generation of researchers builds on the findings of the one before them; there is no "mother lode" to be found. In recognition of their groundbreaking work and the amazing success of their model, the Nobel Prize was awarded to Black and Scholes. The original Black-Scholes Option Pricing Model from 1973 has been refined and adapted by numerous academics since then.

The premise of zero dividends was relaxed by Robert Merton in 1973.

In 1976, Jonathan Ingerson took it a step further by removing the restriction that there would be no taxes or transaction fees.

In 1976, Merton freed us from the shackles of fixed interest rates. The stock option valuation models that have emerged as a result of this development are startling in their precision.

If you think that's dull, try reading some of the articles and equations (I did, and it was not pleasant).

Despite being one of the most mathematically complex fields of finance, contemporary option pricing systems have advanced to the point that they can be calculated with frightening precision. The foundation of most modern models and methods may be traced back to the work of Black and Scholes. The Cox, Ross, and Rubenstein binomial model, which is commonly used with more volatile stocks, represents a significant advancement. In fact, the geniuses are racing to see who can release the most advanced model. The gist of it is as follows:

To determine the theoretical or fair value of an option, a mathematical model is applied. The following are examples of inputs used by option pricing models:

• the underlying instrument's (stock's) price: stable
• indicative of the option's strike price: Fixed
• the number of days left till the due date: Fixed
• the stock's volatility: static
• the interest rate on risk-free investments, such as Treasury Bills: Fixed

While the prediction's track record is solid, traders should be wary of the fact that even little changes in the pricing models may "kill" them. The models are neat in theory, but they are prone to change in the long run. The problem is that most option traders lack the expertise and perspective to recognize changes as they occur. Neither can they account for price irregularities when analyzing an option chain.

That's why I find prescriptive option strategies so annoying. How to execute the trade is specified in the prescription. It specifies the month, strike price, and buy/sell option. That's good as long as prices don't fluctuate and the market remains stable. Ok, in other words, "Hey market, I'm going to trade now. Could you please just stay calm, act really normal, and don't do anything rash until I'm through?" It would be greatly appreciated. I just don't see how that could be true. The main issue with most options traders is that they are unaware of their ignorance.

It could be a smart idea to buy a call option on a stock that has found support and is trending upwards, like it is today. Trading at the "in the money" strike price could be profitable, but it could also be risky. Trading out the next month could be a good idea, but it could also be a bad decision. If you can decipher the pricing structure, you'll find the pitfalls. If the medication can help, that's fantastic. However, this could spell calamity if the market prices are far off. The price of ignorance is not free.

Proponents of new markets

Market makers are a common source of confusion. When a market maker sets the price and sells an option, they are essentially gambling. As the market reacts to the offering, the market maker will make appropriate price changes. They want to maximize the number of traders they have and their profits from most trades. They can use the bid/ask spread and the opportunity cost of waiting to make this work. The market maker is the one who agrees to a potentially risky contract. Either they buy the same option (sell a 45 call and buy a 45 call) or they buy shares to deliver in case of exercise to eliminate the risk immediately. 

They get their risk under control and a modest premium for the deal. When there is a shift in buying and selling pressure (from brokers and/or dealers), sellers adjust their prices accordingly. The store doesn't recognize or carry you. They have little interest in your financial success yet value you nonetheless. Your order volume is all they care about. There are many misconceptions floating around regarding market makers, so it's important to learn the truth about them. (Refer to the prior issue's newsletter titled "Those Darn Market Makers").

Volatility

Volatility plays the biggest role in determining option prices. Using a standard of 12 months of historical volatility, the theoretical option price is calculated. The cost estimates are accurate for that period of time. The trading and pricing of options with short time horizons takes place in an atmosphere where they are vulnerable to the vagaries of the market.

While the present climate is quite unstable, the outlook for the future is often quite stable. That completely disrupts the price model, but it does provide valuable information to astute investors. The market will become irrationally costly and unstable if short-term volatility is greater than historical volatility. To account for the current circumstances (greater perceived volatility), the option's time value is temporarily inflated. The "fluff" can be swiftly withdrawn again if price movement settles down or stabilizes. An increase in pricing, for instance, tends to alleviate market anxiety and volatility. When a stock swings in the trader's favor but the option's reward is less than expected, the trader often feels tricked and violated. The market sighs a sigh of relief, and the previously high volatility drops, reducing their earnings.

The real price is feeding the 12-month volatility and continually modifying it, which is ironic given the gap between the two. Volatility that fluctuates widely from day to day will be averaged out over the course of a year using the moving 12-month volatility average.

In the next issue of the newsletter, I'll explain the X-Factor Options Trading Graph and provide examples of how to visualize the data. Visuals make it simple to understand complex information (stock charts, for example). Trading options without the X factor, as my students like to say, is like trading stocks without a chart.

As long as you don't educate yourself too much, options can appear straightforward. However, if you attempt to understand too much about them, you may become overwhelmed. There is an ideal middle ground. The ten-year-old need not be a manufacturer to get the automobile going, but he will benefit from experience and development before taking the wheel. In the meantime, stay tuned.

I'll see you at the free web seminars and maybe even at my "Trades Forge" two-day trading boot camp.