Option Pricing and its Underlying Stock

Dear Options Trading FAQ:

I saw very very strange and unusual options pricing this morning. A heavily traded NASDAQ stock opened at $63 and moved about one point downside in the first ten minutes of trading. After another ten minutes, it was still down about -3/4. Five minutes later, it was still down, about 1/2. After another five, it was down only 1/8. The total time we're looking at is about 25 minutes.

Ever the hopeful options trader, I was looking at the 65 current month calls. At 8:40, they were 1 7/16--1 11/16. This was when the underlying stock reached it's lowest, down about 1 1/4 points. Ten minutes later, when the stock had risen half a point to around -7/8, the option was at 1 3/8 bid to 1 5/8 ask. Five minutes later, when the stock was down -3/8, the option was at 2 1/8 to 2 3/8.

This seemed to be a **radically** higher price, way disproportionate to the underlying equity. Volume was only 110 contracts. What causes these kinds of huge option price swings?

Swinging in the Rain

Dear Swinger:

We loves a fat, juicy option trading question! I wish you had included certain details, but I’ll give it a whirl anyway. First of all, I’ll assume that your option quotes are on time and that the “lag” that seems to exist between the stock and the options in your story isn’t due to delayed transmission of quotes. Also that there is no news on the stock (or is there?).

Basically your scenario asks a few questions: “When the stock regained 1/2 a point to down 7/8, the option was at about the same price as when the stock was at the low. Why?”

I wish I was watching this one myself - to see if the opening rotation had anything to do with the perceived price jumps. This is how an opening rotation sequence works: Option series are opened up for trading in a certain order. Prices are determined for each month’s strikes in turn. As they go from option to option, the opening “rotation” prices are left on the machine (the quote you see).

If the underlying stock is plunging or flying up, there will be a “jump” in the bid-asks of the options rotated “early on”, after the rotation process is completed (a jump to the “real” price ala the current underlying stock price). In our case, the first quote you mention 1 7/16 to 1 11/16 may be artificially high from the rotation. Did this quote fall quickly from there a few minutes after they started trading?

“But what about the rush up in the options after that?” Ahh, the magic of options. You mentioned that the stock involved is a heavily traded NASDAQ stock.. That means that we have plenty of guys looking at the options (both puts and calls) at the same time as the stock. How did the put options react in all that? As a guess, I would say they opened near their highs and then collapsed. Anyway, what the option hotshots do is to jump on the calls as a “bargain” if they see the stock catching support. The call option premium will swell as they do this to an “unexpected” proportion. Is this what is happening at the end of your scenario?

By the way, when this happens with the call options, the stock traders are heartened and will be encouraged to buy (they would consider the swelling call premium “smart” money). The calls are giving a buy signal.

Again I don’t know if these are factors or not, as I don’t have enough info at hand - but I hope I’ve given you enough to chew on.

P.S. One needs to try to find out how the options “usually” trade. They probably always have a fat premium which makes the valuation swing less dramatic. If it sprang right back to “normal” levels, then folks are saying that all is “OK” for the stock.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Valuation, Options Pricing

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