Option Pricing Valuation

Options Trading Topic: Option Pricing

Dear Options Trading FAQ:

Can you explain any popular wisdom on option prices to a novice trader? I've noticed that the prices of options are *not* linearly proportional to how much they are in or out of the money. Is the best bargain usually bought just in or out of the money?

Also: I've only watched stocks in the $70 range--is an option that is $5 in the money proportionally more expensive for a cheaper stock since the percentage gain for stockholders is proportionally more? Or does the price "roll off"?

Trying to Figure Out Option Pricing

Dear Go Figure:

I note your use of "popular wisdom". Careful! This can be deadly depending on who you are listening to. Generally speaking, the speculative option account is considered a contrarian indicator. It is very important to try to distinguish between smart and dumb option money. With the right tools, the small but savvy individual trader can do well in discerning which option money flows to follow. As long term readers can tell you, that is one of my favorite subjects.

More in the future on options trading.

You pose some thoughtful questions which can be addressed from two perspectives: theoretical (Black Scholes) and empirical (market savvy). First the textbook discussion and then on to the real world stuff.

As discussed a couple of weeks ago, the mathematics of the option valuation formula is not linearly based, and so, far from intuitive. The intrinsic value is but one of the inputs. Of course, in a deep in-the-money option, it can be the primary source of its value. However, as you point out, the stock's prices swings in terms of real ticks and as a percentage of its value depends on the price of the stock. This will be addressed in the volatility portion of the formula, but, as we said, it is the most difficult component value to assign.

As in many areas, the intuitive sense of a human trader can be more sensitive than any program you come up with. Ask any tape reader what a certain option with such and such time remaining is worth and he'll often surprise you with a very close answer. Of course such a feel for what is right or wrong with a certain option's premium takes quite a bit of time and devotion to develop.

A factor the savvy trader takes into account that formulas miss is the extra "speculative" demand caused by option traders. The most famous example is the secular rise in OEX put premiums since the Crash. Portfolio hedgers and Black October Aficionados are fond of bidding up puts as a whole for protection. Also, because of the swell in the ranks of new, "little guy" option accounts, the out- of-the-monies are more popular than ever. Have you checked out the premiums of the way-out strikes of these tech and net stocks lately? Or how about the extra pressure caused by media reports like Dorfman? Option shooters will bid up the strike or two above the current price where as more controlled players will target the at- the-money series.

The general advice we tend to give is to stay close to the current stock price. Usually the far out strikes are pure crap shots. You'll find more value in the very near or at the money options. They may cost more, but can be well worth it. They help when you turn out to be wrong - they'll hopefully retain value much longer than the real speculative strikes. While your at it, try to pay for that extra month, too. How many times would have an option worked out if you had that extra month? Also, as mentioned, value players will gravitate to these options and may not be quick to sell in a downdraft. The more shaky holders of the out-of-the-money options, on the other hand, may be very quick to panic out of their positions, leaving you holding the bag.

Did I get around to answering your question? I don't know, but I'll sign off before hogging up any more bandwidth ;)

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 Pricing, Options Valuation

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