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Software for Pricing Options
by Kenneth R. Trester
and Robert P. Swanson
Chapter 1 - Introduction
OPTION MASTER®: Your Bluebook to the Options Markets
OPTION MASTER® is designed to help you determine whether a
stock, index or futures option is fairly priced, and to determine
whether an option is over- or underpriced. Similar to the purpose
of the "blue book" that is utilized in the used car
market, OPTION MASTER® is designed to tell you what the fair
price of an option should be in a quick and easy manner.
OPTION MASTER® allows you to select the best option for a
stock, commodity or index such as the S & P 100 Index, and
does this by evaluating all of the options for that index,
determining what their fair price should be. Unlike other option
pricing programs, there is no need in this program for accessing
an expensive data base, incurring high telephone charges, or
buying additional hardware. Just a few easy entries into OPTION
MASTER® will allow you to determine the fair price for a whole
set of options. OPTION MASTER® is so easy to use that within a
few minutes you can easily evaluate all the options for a whole
series of stocks, indexes or commodities.
Options Defined
For option novices, much of the confusion regarding options
can be removed if you look at listed options as side bets. Call
options are side bets that the underlying common stock (index or
futures) will rise in price above the strike price; put options
are side bets that the underlying instrument will fall in price
below the strike price.
These side bets have time limits of a few days to several
years. The price you pay for this bet is determined on the option
exchanges, and the price changes from moment to moment during the
trading day. The price you pay for a put or a call is usually
determined by the time left in the option (the expiration date),
and how close the underlying stock price is to the strike price.
For example, a Ford Motors March 40 call is an option that
expires on the third Friday in March. This option's strike price
is 40. Each option is for 100 shares of stock, so if this option
is priced at 1/2 (or .50), it is really priced at $50 (.50 X 100
= $50). Options that are not past the strike price are
out-of-the-money.
The price you pay for out-of-the-money options is purely the
anticipated value of the option. In other words, this price is an
anticipation of the real in-the-money (or into the strike price)
worth of the option at expiration. If the underlying stock price
does not move through the strike price before the expiration
date, the option will have no value.
For each point that the underlying stock price is
in-the-money, the option is worth $100 more. For example, if Ford
Motors is priced at 44, a Ford Motors 40 call in March before
expiration would be worth at least $400. When there is little
time left before an option expires, the anticipated value (or
time value) of the option is quite small. Here, out-of-the-money
puts and calls will have cheap price tags. In other words, you
can make a small investment, with a chance to make a large
profit.
The Importance of Option Pricing
The most important key to success in the options market is not
picking the right stock, but paying the right price for an option
when you buy one, or when you write (sell) an option. Almost all
market makers on the option exchanges and most option
professionals are using option pricing models like OPTION
MASTER® all the time to determine whether options are
underpriced or overpriced according to such pricing models.
Now, with OPTION MASTER®, you have the same advantage that
the professionals have. The pricing of options is so important
because when you pay too much for an option -- even if the
underlying stock or commodity futures price on which that option
is purchased moves in the right direction -- you probably will
not get enough reward for your potential risk. In a sense, you
have stacked the odds against yourself. On the other side of the
coin, when you buy underpriced options, you will get far more
rewards compared to your risks when the underlying stock, index
or commodity moves in the right direction. Now you have stacked
the odds in your favor.
The goal of all option investors should always be to buy only
options that are fairly priced -- and better yet -- underpriced
according to a pricing model such as OPTION MASTER®. (Investors
who write options should always attempt to write options that are
overpriced, where they will receive more premium than the fair
price of the option.)
Always remember: when you buy overpriced options, you stack
the odds against you, but when you buy underpriced options, you
stack the odds in your favor.
The Determinants of the Option Price
There are several factors that determine what the option price
will be and how the option price will change. These include the
following:
- The underlying stock, index or futures price.
- The strike price.
- The volatility of the underlying stock or futures price.
- The time left until the expiration date of the option.
- The short-term interest rate.
These five factors are the key determinants of the price of an
option, and most of this information can be found in most major
daily newspapers, except for measurement of price volatility.
However, we have a special section in OPTION MASTER® for
measuring volatility quite easily using the data that is
available in the daily newspaper. Therefore, with your newspaper
in hand, you can easily determine the fair price (true worth) of
most options quickly.
Where To Start
Most investors approach the options markets by first finding a
stock or commodity that they think is ready to move, and then
look to the options market to pick an option. However, if you
prefer to play the market as a whole, when you think the stock
market is going to move up, you can choose an index, such as the
S & P 100 (OEX) Index, and then select a call option on that
index, hoping to participate if the whole market moves up in
price.
Here your goal should be to select the best priced option that
is available for the underlying stock, index or commodity that
you like, and if all the options are overpriced, you should pass,
and move on.
Option writers should be doing the opposite. If they want to
write (sell) options, they should try to select the most
overpriced options, and they should pass up stocks or commodities
where all the options are underpriced.
Another approach to the options market that is a little bit
unorthodox -- rather than picking the stocks, commodities or
futures in the market and then looking at their options, first
try to find the most underpriced options by using OPTION
MASTER®, and then from there, select the best stock or
commodity. In this instance, by choosing underpriced options, you
have stacked the odds in your favor to begin with, and now all
you have to do is to identify an underlying instrument that has a
good probability of moving in the right direction.
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