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Software for Pricing Options
by Kenneth R. Trester
and Robert P. Swanson
Chapter 8 - The Secret to Success in the Options Game
The Forgotten Secret to Success
In the options game, there is one secret to success -- this
secret is followed religiously by the market makers and
specialists on the floors of the option exchanges. Yet most
investors do not follow this important action. Surprisingly, this
simple secret provides an unusual advantage in the options market
that is not available in other investment markets.
Unlocking the Secret
The secret to successful investing is always to identify an
investment that is priced below its true value. But what
is the worth of a share of IBM stock, or one ounce of gold, or a
two-bedroom house? Finding assets that are being sold at less
than their true worth is a goal of every investor, yet in most
cases, the tools to measure true worth are difficult to find, if
nonexistent.
Consequently, the majority of investors and analysts fumble
with systems for selecting undervalued investments that are
founded on superstition and wishful thinking. But the options
market is the one place where the tools to scientifically analyze
true value exist, and are available to every investor.
The unique nature of listed put and call options enables their
true values to be determined by statistical and computer
analysis, thus allowing you to spot genuine bargains.
Why Options?
The value of a stock option is dependent on price changes in
the underlying common stock against which the option is trading.
Naturally, the majority of option investors purchase options
based on their assessment of the underlying common stock. Usually
investors will, for example, buy calls on stocks that are priced
below what they feel is their true value, or when they believe
that the common stock price will move up in the present market
environment for a variety of prevalent reasons. But the true
value of a common stock is hard to determine, although investors
are always trying.
Some use systems of fundamental analysis -- studying corporate
earnings, net worth, market shares, etc. Others use technical
analysis -- studying past price movements.
Evidence indicates that fundamental analysis is helpful only
in determining long-term potential movements, but in the short
term, a stock's price is influenced by investors' emotions,
unpredictable economic conditions, unexpected news events, and
other factors that tend to cause the price to move in a random
pattern.
If we can assume that short-term stock price moves are truly
random -- and the body of statistical and scientific evidence
supports this position -- then we have a basis for measuring the
real worth of individual options. Nevertheless, investors believe
in their ability to predict short-term price movements, and are
constantly wagering on their ability to do so. We, of course,
believe there are some services and statistical measures that can
outperform the random market in the short term, but short-term
stock price actions do approach randomness.
Therefore, the intelligent way to invest in the options market
is to assume that the market is random in the short term, and
make your moves accordingly.
It is the random nature of price movements, coupled with
investors' ignorance of this phenomenon, that provides the
foundation for locating undervalued or overvalued options on a
scientific basis.
Listed options have a very short life. This makes their values
highly dependent on short-term random moves in the prices of the
underlying stocks. If you are able to determine the degree of
volatility of a stock (the average amount the price fluctuates up
or down in a given time), and you can assume that the price
fluctuations are random, you can apply statistical and computer
analysis to determine what the probability is that the price will
be higher or lower at some particular time in the future.
With this information, it is then relatively easy to determine
the proper price for an option, and to determine whether
its present price is too high or too low.
A Matter of Odds
Investors have a hard time understanding the pricing of
options. When an investor identifies an option as being
underpriced, and later sees that option expire worthless, he then
assumes he was wrong, and the option was not underpriced, for it
became worthless.
But to understand why an option is underpriced or overpriced,
you must understand the laws of probability and odds.
When we say an option is underpriced -- we say in the long
run if you buy an option over and over again and hold it for
the same exact period of time, your overall result would show a
gross profit on that position. Of course, that is only a
theoretical profit, because there is no way to buy the same
option under the same conditions thousands of times.
But many option players need immediate gratification. If they
lose on various options, they begin to think that the price of
the option means nothing, and they resort to looking only at the
underlying stock or future's prospects, and forget the option's
price -- which is a faulty approach to the options market.
Understanding that you can lose in the short term but win in
the long term is as simple as flipping a coin. For example, when
you flip a coin, you have a 50% chance that the coin will turn up
heads. Flip it 10 times, and you might see heads come up only 2
times, or it might even come up 7 or 8 times, rather than 5
times, which are the true odds. When you flip it 1,000
times, however, the probability is that it will turn up heads
very close to 500 times. The greater the number of flips, the
higher the probability that the results will be 50% heads and 50%
tails.
This same phenomenon is true in all situations where random
events are concerned, such as the options market. When you buy
options that are underpriced, according to the laws of
probability, you may lose many times, but in the long run, you
will win.
The Secret - Scientifically Pricing Options
The secret then to successful options trading is to buy
options that are underpriced and sell options that are
overpriced. Better yet, in the options market you have the rare
ability to measure the true worth of your investment (options)
easily through scientific means.
But if the real worth of any option can be quickly and clearly
measured, then why are all options not priced at their true worth
in the options market? Like any investment market, the options
market is filled with investors and speculators who think they
can predict the unpredictable. They believe they can predict
short-term moves in the stock market (but most of them can't).
Therefore, they purchase options based only on the merits of the
underlying stock, without bothering to look at the price of the
option itself. In addition, the emotion and uncertainty present
in the stock market is magnified in the options market. Options,
being highly leveraged instruments, exaggerate the emotional
optimism or pessimism of the market, causing option prices to
vary widely from their true worth.
The Key to the Treasure Chest
The key to determining the true worth of a put or call
revolves around identifying the volatility of the underlying
stock or futures. Most common stocks and futures usually have a
consistent volatility pattern over the years. By measuring the
average price volatility for the past three to five years, an
estimate of future volatility can be obtained. If you can combine
your longer-term volatility estimate with a short-term measure of
volatility, you can better pinpoint the future volatility of the
underlying stock or futures.
The more time spent in estimating the price volatility of the
underlying stock or futures, the more accurate you will be in
determining the true worth of a put or call.
The Art of Pricing Options
If pricing options is the key to success in the options game,
how can you as an investor scientifically measure whether an
option is over- or underpriced? The professionals and market
makers on the options exchanges use computers to determine
whether options are over- or underpriced, and they usually use a
pricing formula called the Black & Scholes model, or a
variation of that pricing formula. The Black & Scholes
pricing formula estimates what the market price of an option
should be, and it does this by determining the cost of creating a
perfect hedge in the market, using options and stocks or futures.
The Black & Scholes model provides a good estimate of the
true worth of an option, but because it weights interest rates,
it, in some cases, distorts that true worth when interest rates
are high. We use the Black & Scholes model for determining
prices at times, but we also use our own pricing system, which
takes a probability distribution, and uses a form of computer
simulation to measure true worth.
But from a practical point of view, don't be alarmed by the
mathematics of measuring the proper price of an option. Many of
the established methods for scientifically pricing options can be
followed, and any method is better than none. The important
consideration is that you make some attempt to determine whether
an option is over- or underpriced.
Here are some suggested ways to handle the pricing of options.
First, approach the pricing of options the way you approach the
pricing of a used car. When you buy a used car, you should have a
blue book in hand to measure what the proper price should
be. In the options market, when you attempt to find some puts or
calls for purchase, you of course select stocks that you feel are
the best prospects for option buying.
Your next step is to identify what are the best options
available for option buying. Here, to ensure that you are going
to be buying the best priced options, you need a blue book, and
that blue book could be The Option Player's Advanced Guidebook
(available from Institute for Options Research, Inc., P.O. Box
6586, Lake Tahoe, Nevada 89449 for a price of $35.00 plus $4.00
for shipping and handling). This book has 160 pages of pricing
tables that can be used to make an estimate of what the price of
an option should be. After looking up your chosen option in the
tables, you would then compare it to its actual price in the
market today.
This is a broad brush, simple and fast method of pricing
options. Better yet, you can compete with the professionals by
using your own home computer to measure whether an option's price
is undervalued or not. OPTION MASTER® can be used on a almost
all computers, and does a sophisticated job of pricing options.
(Here you can become far more exact in measuring the real worth
of an option price.)
There is another alternative, and that is to use option
advisory services where much of the work in identifying
underpriced options has been done for you, such as the Trester Complete Option Report, where many man-hours are spent
identifying the best underpriced options in the market. (Be wary
of advisory services that recommend options, but ignore option
prices.)
Whether you use an advisory service, your computer, or a book
to price those options, some attempt must be made to make sure
that the options you are purchasing are, at the very least,
fairly priced; better yet, that the options are underpriced if
you are buying options, and overpriced if you are writing
options.
Just remember, the difference between a professional and an
amateur in the options market is determined by the amount of time
spent pricing options. Regardless of what you think the
underlying stock or commodity will do in the future, don't buy an
option if it is overpriced, or write an option if it is
underpriced. When you buy overpriced options, you are no
different from the gambler who throws his dollars into the slot
machines in Las Vegas. In the end, you will lose.
To improve your skills in pricing options, do some homework by
studying The Option Player's Advanced Guidebook, or one of
the other books available on pricing options, such as Option
Pricing & Strategies in Investing, and Strategies for
Put & Call Option Trading.
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