Options Pricing and Options Trading

[dominover 10]

Hi

I suppose this could relate to all derivatives but I'm particularly interested in equity options.

Can someone answer this question.

I have always been baffled as to why one would price derivatives using binomial or Black Scholes models for derivative pricing. I am assuming it is so one can work out the price of the option and only trade that option when the market price (separate from the calculated price using Black Scholes or whatever) falls below the calculated price using a derivatives pricing model?

 

Is this a correct assumption or am I completely on the wrong track?

 

Thanks

[dominover 10]

I'll answer my own question. Found this snippet on the web. I understand now.

 

Option traders generally rely on the Black Scholes formula to buy options that are priced under the Black Scholes formula calculated value, and sell options that are priced higher than the Black Scholes calculated value. This type of arbitrage trading quickly pushes option prices back towards the Black Scholes Model's calculated value. The Model generally works, but there are a few key instances where the Black Scholes model fails.

[dominover 10]

Maybe someone out there uses this method when trading derivatives. Do you use Black Scholes or Binary models? Does anyone use this system?

[SIUYA 11]

market makers use this type of strategy - in a general sense of it.

 

there are many types of models and many types of variations but the concept is the same. A market maker buys and sells options that a relatively priced to each other based on a model in the hope that they do enough trades and take a small margin from each trade around the theoretical model prices.

Then they hope that the theoretical model represents reality closely enough that if they are left with residual open option positions (ie; those that they could not close out with different clients buying and selling) then they have enough margin or buffer to not lose much money.

Of course as this is an ongoing process of continual spreading and trading by a market maker it cant simply be thought of as a one or 2 off options trade strategy.

 

For the retail or institutional guy the use of theoretical option pricing is used differently as they are not necessarily doing many many many trades but often one off, directional or hedging trades.

Remember - all of the models are simply theoretical models that represent what the options are supposedly worth at that point in time relative to other options. Any change in any of the parameters for the model or changes in supply and demand then changes the prices in the model - the key point is the relative pricing.

 

Prior to the models people traded options in much the same way, however the models give more precise prices for relative trading.

[dominover 10]

Hi.

Thanks for that. I was starting to wonder if there was anyone out there.

I'm a little confused as to what you mean by relative trades? Are you referring to the market price of the option as opposed to the calculated price using a model? Or, are you referring to different option series (relative to each other). Not sure how that applies though.

[SIUYA 11]

your question - "I'm a little confused as to what you mean by relative trades? Are you referring to the market price of the option as opposed to the calculated price using a model? Or, are you referring to different option series (relative to each other)."

 

a model simply provides a guide to what each option strike and series is worth relative to the other options.....so the relative aspect applies to all things you mention.

 

-- the bid ask spread of an option price in the market is usually relative to the model and its theoretical fair value.

--- and due to the constant spreading market makers will do, the options are relative to other options.

 

You have to remember that a MM thinks and acts differently to a single strike/series option person. they are constantly spreading relative values and risk and using a model to help keep things in line. Whereas a single option trader might be looking at a choice of which options to purchase based on a number of factors....one of thise might be, which series or strike is cheapest.

 

As in options there is no easy answer as there is a lot going on. Once you understand more about put call parity, synthetically reproducing options and that options are about the transference of risk some of it may make more sense.

 

(as a new subscriber your posts may have been delayed - stops spamming - plus while many trading message boards have falling attendances and traders lab is a little bit quiet - it is also a lot more sensible and less toxis than some other message boards)

[dominover 10]

Ok, thanks.

 

I suppose my next question is then, if I, as a home investor, wanted to price option series then is all that data available to me. I understand underlying historical share prices (which isn't too hard to get) is important. Do investors generally price options and if so how do they go about it.

 

I do understand how to apply Black Scholes to determining option prices as I have studies this area and have applied it in the past. I suppose, I'm trying to get a sense of the reality out there regarding how home investors go about option pricing. My guess is that they generally don't price them but instead apply equity market logic to determining value.

 

If I was to take this on as a project.. maybe write some computer programmed models for option prices to speed the process up a little, then my main concern would be data. Maybe I should ask whether there are data providers who provide a full set of outputs specifically for this purpose.

 

I find equity options very interesting and may soon work on a few things to assist me in the process of trading these.

[SIUYA 11]

dont reinvent the wheel there are plenty of option price models in Excel out there and all you need it the input parameters. You dont need massive amounts of price data.

 

You would be better understanding what makes the cheap or expensive and then seeing if you scan for those

[dominover 10]

dont reinvent the wheel there are plenty of option price models in Excel

 

Name one Option Pricing Model in Excel?

[Seeker 11]

Option traders generally rely on the Black Scholes formula to buy options that are priced under the Black Scholes formula calculated value, and sell options that are priced higher than the Black Scholes calculated value. This type of arbitrage trading quickly pushes option prices back towards the Black Scholes Model's calculated value. The Model generally works, but there are a few key instances where the Black Scholes model fails.

 

There is a lot of misinformation that the Black Scholes formula determines the price. Throw that out, because it's not true. The market determines the price, not the formula. Banks know the true value of Black-Scholes, and it's not the price it gives. Banks don't use Black-Scholes to price options. And you'll see why below.

 

So let me at least back up what I'm saying. Suppose you do believe the Black-Scholes price is the correct price. Then looking at the formula you will see that you need some parameters, to calculate that price, the spot, the maturity etc, but the key one for this discussion is the volatility. So what are you going to choose for this key parameter?

 

You may think that you can calculate some standard deviation for the stock and use that? If so, you'll lose money to the banks. Because you'd be using the wrong volatility. And worse, the banks and the market makers won't even need to take risk to make money from you. They will chew you up, because they know what you don't, there's a way to eliminate your risk on an option position, and there's only one volatility that matters here, and that's the implied volatility. In other words the volatility that is implied by the market price.

 

So then what is the point of Black-Scholes if it doesn't give the price? Well the key thing that Black-Scholes does is that it tells you the implied volatility and it tells you how to delta-hedge the option to eliminate your risk.

 

Good luck with your learning dominover. but be wary of snippets online like the one I quoted in this post. It's wrong and will lead you astray.

[dominover 10]

Good explanation. Thanks. I'm aware of implied volatility and the importance of it.

I've heard this before, that option pricing models are limited in value. I don't trade options myself by I make the below assumptions.

 

If I am not using an option pricing model, an awareness of the equity market s(for equity options) combined with implied volatility are presumably the best tools for determining where value is in options

 

I would also assume that this can work the other way. Implied volatility may give some strength to market sentiment for a given underlying and can therefore be used as an indicator for possible price moves in the equity market.

 

Are my assumptions correct?

 

Thanks

[SIUYA 11]

 

If I am not using an option pricing model, an awareness of the equity market s(for equity options) combined with implied volatility are presumably the best tools for determining where value is in options

 

Everything in options is about relative values and risk transferrance. Simply saying something is cheap or expensive is pointless. you need to say its cheap or expensive compared to ......historical volatility,or next months options, or front month options or based on certain parameters in what ever model you use. Certain options are relatively cheap/expensive based on supply and demand as well. There are many factors. This is why people use models to help determine relative values....regardless of if the model is right or wrong or does not necessarily reflect reality or supply and demand at present.

 

I would also assume that this can work the other way. Implied volatility may give some strength to market sentiment for a given underlying and can therefore be used as an indicator for possible price moves in the equity market.

 

Are my assumptions correct?

 

Thanks

 

no....implied volatility basically reflects the markets view on what future volatility will be - not necessarily what sentiment for direction. Think about these scenarios....a very volatile market that really goes no where, or a trending market with low volatility (like now). These are different things and might not reflect each other, plus there is as Seeker mentioned the actually supply and demand for the risk transferrance that options provide. You might have a lot of bulls who are selling calls...and /or puts but are still bullish. Too many scenarios exist to make general rules and assumptions.

[dominover 10]

no....implied volatility basically reflects the markets view on what future volatility will be - not necessarily what sentiment for direction. Think about these scenarios....a very volatile market that really goes no where, or a trending market with low volatility (like now). These are different things and might not reflect each other, plus there is as Seeker mentioned the actually supply and demand for the risk transferrance that options provide. You might have a lot of bulls who are selling calls...and /or puts but are still bullish. Too many scenarios exist to make general rules and assumptions.

 

I'm just pondering ideas here. Just a discussion and I'm not disagreeing with what you are saying.

 

The reason I make the assumption that implied volatility may provide something of a proxy for the sentiment in the underlying (say equity) markets is that there would be a reason for the predicted volume surrounding turning points in the market. If value does in fact have some impact on turning points in the market for options and shares then I would logically assume that implied volatility (forward looking) would could provide some insight into turning points. I don't know this from experience of course, it's just ranking the logic in my mind.

 

So if implied volatility does not indicate which direction the market is heading or is perceived to be heading by a certain date then I make another assumption. That is, if the underlying market is expecting to climb the why not buy the underlying instead of a call option to benefit from that price rise. Benefiting from a price rise would in fact be lower risk if you bought the underlying instead of the option because a fall in price does not necessarily mean everything is lost. But then again, i have no doubt the leverage gained from buying calls and then selling them when they are well in the money would be more profitable. There's just more risk. Compared to the option, if the price dies not rise before expiration then the contract price is lost. Thus.. from this.. I would make the assumption that future implied volatility could be a gauge of predictions of future put option activity. Therefore, if put option activity is predicting in a bull market the it could possibly be an indication of a turning point in the market from bull to bear.

 

As I said, this is just a discussion and I'm not disagreeing with your explanation. I just like to ponder these things because if I was the market I know what would make me buy or sell options or shares and thus, billions of me might do the same

 

I think an important point to consider is that options have a time constraint whereas the underlying does not necessarily. Concentrated activity in options I would probably make the assumption that this activity is for a reason. A bullish trader who buys puts may do so for a certain period because by that puts expiration, he may expect it to move further into the money and thus trade it or exercise it. :missy:

 

Maybe, maybe not? I don't necessarily believe any one thing but I like to discuss these things so I can rule them out ..

 

Thanks for the replies.. Please respond if you can make sense of my post.

Edited September 11, 2014 by dominover

[Guest muhitalam]

Maybe someone out there uses this method when trading derivatives. Do you use Black Scholes or Binary models? Does anyone use this system?

 

Hello dominover,

 

I don`t still use Black Scholes or Binary models. But I am thinking to use Binary models. If you have any ideas with this help me.

 

Very much looking forward to hearing from you

 

Thanks