Option Pricing
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Option Pricing
In this lesson we are going to cover how an option gets its price.
Keep in mind that an option is something that is being bought and sold all day
long and the only reason it has any value is because someone is willing to pay a
price for it.
That is why the prices fluctuate so much.
And since options are derivatives it is much harder to determine the price of an
option.
There are 5 major components of an options price:
Stock price of underlying
Strike price
Volatility
Time to expiration
Short term interest rates
The most popular formula for determining the price of an option is called the
Black-Scholes Options Pricing Model. The work of this model was so
groundbreaking that the creators won a Nobel Prize in Economics.
And here is the actual formula:
Now I know this is a course on options trading. And I know a lot of you will be
wanting to know how to use the formula to calculate option prices. But I have
something to share with you.
You don’t need it.
That’s right. You don’t need to know how to price an option.
I firmly belief that trading should be kept as simple as possible. And that is why I
have never bothered to learn the formula or have ever used it.
What I do is let my broker do the work for me. In my trading I rely a lot on my
broker’s software to do almost all the calculations for me.
The software allows me to calculate options prices, breakevens on trades,
probability of profit, and more based on the Black-Scholes model or by using a
couple other pricing models.
For that reason, I am not going to focus on the actual formulas.
What I want to focus on is the stuff that you need to be aware of so that you can
get to trading as soon as possible.
Then once you get good at the basics and you want to really get into pricing and
finding trades based on pricing errors you can pick up a book like Sheldon
Natenberg’s Option Volatility & Pricing.
Pricing basics
Here are some things to keep in mind when trading.
1. The more expensive the stock, the more expensive the option. This matters
because most of the time dealing with low priced stocks is not worth it for us as
option traders.
2. A quick move in volatility can really change the options price.
Volatility is basically movement or the possibility of movement. When the
volatility of an option is high the options will be worth more. But the volatility will
only be high is something is about to happen. If there is some uncertainty in the
market.
Volatility also increases when there is fear. So when a stock drop, Volatility
increases. When a stock is moving higher, volatility usually decreases.
As option sellers, we want to sell when prices are high. But that also means that
volatility is high, and volatility can hurt us.
3. If the return on a prospective trade seems too high, you are probably missing
something.
Once you develop your own trading plan you will start to execute the same trades
over and over. Eventually you will get a feel for what a particular trade should
yield. If that yield is too high, then beware, you have overlooked something.
The only way the yield can be too high is if volatility is higher than normal because
of an upcoming event or uncertainty about the stock.
You should either dig further or look for another trade.
I learned this the hard way a few years ago when I was doing buy-writes on LVS.
Normally, I like to do covered calls that result in 3-5% or so monthly returns. But I
found some that were paying 14% returns in just 30 days. I couldn’t believe it. So I
bought a few hundred shares and sold calls against them.
The returns were so juicy that I got greedy so I bought a few hundred more.
After a week the stock tanked. It lost over half its value and eventually bottomed
at less than $1 a share.
I was beside myself. What the heck was going on?
I turns out that the company was highly leveraged and was having trouble paying
its loans. The street knew this and thus priced in the extra volatility in the options.
I, being a fool at the time, did not know anything was amiss and was taken for a
ride.
So be careful. If any trade is offers too much %, dig deeper. Chances are you made
a mistake in analyzing the trade. Maybe you are looking at options for the wrong
expiration month, or the wrong strike. From time to time, you will come across a
situation like LVS where the yield will seem too good to be true and you won’t be
able to figure out why. In that case, just ignore the trade.
4. Watch the VIX
The VIX is the implied volatility level of the S&P 500 index options.
Often referred to as the fear index or the fear gauge, it represents one measure
of the market's expectation of stock market volatility over the next 30 day period.
Knowing where the VIX is will give you a good idea of how volatile things are in
the markets.
Back in 2007 when the markets tanked, people lost a lot of money. And most of
them never knew what hit them.
If they had been watching the VIX they would have known something was up. The
VIX went from around 20 at the beginning of the year to over 80 when things
were really crazy.
When you see the VIX moving up and down in huge chunks, making moves over
one standard deviation on a daily basis, alarms should be going off in your head
that something is not right and to either buy some protection or exit the market
because something is coming.
As option sellers, we do not need to be in the market everyday or even every
month. When things gets too uncertain it is best to move aside and exit your
trades.
In the beginning, as you are learning how to adjust your trades you will want the
markets to be calm. In a crazy market, things move too fast. In that situation it is
best to not trade at all.
Summary:
For our purposes we are not going to worry about if a particular option is under or
overpriced. We are going to evaluate all prospective trades based on criteria we
have. If the trade meets our criteria we will move forward. If something seems
out of whack we will just move on to another trade.
In some cases when the potential profit of our trade is much higher or lower than
normal we will re-evaluate the trade to determine why.
And if the VIX or our favorite stocks start to make wild swings of over 1 standard
deviation on a regular basis we will be prepared to either exit or play with more
caution.
