Option Pricing and Better Trades
Option pricing is a mystery to most traders. They struggle to comprehend terms like implied and historical volatility or intrinsic and time value, or the "Greeks" (Delta, vega, theta, gamma, rho…). These terms are intimidating and my experience suggests that at least half the folks you hear talking about them do not really understand very much about them. It is important to at least be intellectually honest about it and know what you don't know. It is also a good idea to debunk your vocabulary and get what you do know (or think you know) right. And because it is easy to get a head ache from trying to read and comprehend the myriad of equations and models generated from minds of multi-degreed scholars speaking a language only they seem to understand, it is comforting to know you do not have to learn a whole lot about the technical math soup.
It is however, mandatory that you gain some working skills in how to recognize and flow with the option prices or you will get whipsawed and shredded by them. It is not unlike the engineering, manufacturing, physics and computer technology that goes into a modern car. Any 10 year old can start it and drive down the road or off a cliff. The skill to use it correctly is mandatory but the technical wizardry to understand and construct it is not. So option pricing must be understood in order to trade with any consistency.
One major point is that option pricing is not static or consistent. The pricing structure is a moving target because the interaction of the market and the Market Makers constantly adjust the pricing. Price comes from the floor… Models come from laboratories and do not dictate where the price will go. Rather, they try to predict it. Historically, the idea of options is not new. Ancient Romans, Grecians, and Phoenicians traded options against outgoing cargoes from their local seaports. Modern techniques derive their impetus from a formal history dating back to 1877. * 1877- Charles Castelli wrote a book entitled The Theory of Options in Stocks and Shares. * 1900- Louis Bachelier is recognized for the earliest known analytical valuation for options. His work interested a professor at MIT named Paul Samuelson.
* 1955- Samuelson wrote an unpublished paper titled, "Brownian Motion in the Stock Market." * 1956- A. James Boness wrote, "A Theory and Measurement of Stock Option Value". His work served as a precursor to that of Fischer Black and Myron Scholes. * 1969-1973- Fischer Black and Myron Scholes introduced their landmark option pricing model No one discovered the "mother lode" but rather successive scholars added to the work of predecessors. Black and Scholes were noted with the Nobel Prize because of their leap forward and the remarkable accuracy of their model. Since 1973, other scholars have expanded the Black and Scholes Option Pricing Model. * 1973- Robert Merton relaxed the assumption of no dividends. * 1976- Jonathan Ingerson went one step further and relaxed the assumption of no taxes or transaction costs. * 1976- Merton removed the restriction of constant interest rates.
The results of this evolution are alarmingly accurate valuation models for stock options. Ok, you think that is boring you should read some of the papers and equations (I have and it was not fun). Modern option pricing techniques are among the most mathematically complex of all applied areas of finance but they have reached the point where they can calculate, with alarming accuracy. Most of the models and techniques employed today are rooted in the Black and Scholes model. One notable major advance is the Cox, Ross, Rubenstein binomial model widely used in more volatile stocks. In fact the brainiacs currently have 7-9 different models out there trying to out do each other. Here is the basic idea… Option Pricing Model: A mathematical model is used to calculate the theoretical or fair value of an option. Inputs to option pricing models typically include: * the price of the underlying instrument (stock): Fixed * the option strike price: Fixed * the time remaining till the expiration date: Fixed * the volatility of the stock: Fixed * the risk-free interest rate (e., the Treasury Bill interest rate): Fixed The historical accuracy of the prediction is quite good but short term variations to the price models can and do "Kill" traders on a regular basis.
In the long run the models are cool but they are THEORECTICAL and subject to CHANGE!!!!! The difficulty is that the vast majority of option traders do not have the knowledge or even the viewpoint to see the variation when they come. Nor are they able to reflect anomalies in the price structure when they look at an option chain to get a price. This is one of the reasons I so dislike Prescriptive Option Strategies. The prescription dictates how to make the trade. It dictates buy/sell, strike price and which month. Well that's just fine if the market stays constant and the price structure does not move. Ok… so "hey market, I am going to trade now… could you please just stay calm and act really normal and don't do anything rash until I am through? Thanks, that would be real nice of you." Somehow I don't think it works that way. The real problem with most option traders is that they don't know what they don't know.