Weekly Stock Options Trading Tips: June 27, 2009

Stock Options Trading Idea of the Week

How Stock Option Prices are Determined

This week we will take a step back and review the components that determine the value of an option.  These components are the variables in most mathematical models designed to calculate the theoretical value that an option should be trading for, including the most popular Black-Scholes Model.

Terry

How Stock Option Prices are Determined

Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices.  Usually, they meet somewhere in the middle and a price is determined.  This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.

There are 5 components that determine the value of an option:

1. The price of the underlying stock

2. The strike price of the option

3. The time until the option expires

4. The cost of money (interest rates less dividends, if any)

5. The volatility of the underlying stock 

The first four components are easy to figure out.  Each can precisely be measured.  If they were the only components necessary, option pricing would be a no-brainer.  Anyone who could add and subtract could figure it out to the penny.

The fifth component – volatility - is the wild card.  It is where all the fun starts.  Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company.  Volatility is absolutely the most important (and elusive) ingredient of option prices.

Volatility is simply a measure of how much the stock fluctuates.  So shouldn’t it be easy to figure out?   It actually is easy to calculate, if you are content with looking backwards.  The amount of fluctuation in the past is called historical volatility.  It can be precisely measured, but of course it might be a little different each year.  

So historical volatility gives market professionals an idea of what the volatility number should be.  However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.

We’ll continue this discussion of volatility and why it is the most important variable in option pricing next week….

Any questions?   I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s)  or give him your thoughts.

You can see every trade made in 7 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here.   Why wait any longer to make this important investment in yourself?

I look forward to having you on board, and to prospering with you.

Terry

Andy's Market Report

The summer doldrums have arrived and we should be in for a wild ride as a result. Volume was once again low this week and other than the FOMC meeting this week the economic calendar was mostly bare. For the most part the market went unchanged with the Dow taking the largest hit, losing 1.2% for the week.
 
"The rally will get choppier and more selective over the next nine months," said John Dorfman, chairman of Thunderstorm Capital LLC in Boston.
 
"The market never moves in a straight line and it had almost a straight line movement from March 9 to June 12," Dorfman said, he said referring to the 40 percent gain from a 12-year low in the S&P 500 index and its recent peak. "One should expect periodic corrections."
 
The week began on a sour note with the S&P declining 3.1% on Monday. The drop was due to the World Bank cutting GDP forecasts on the U.S. as well as several other countries. Sentiment pushed towards the bearish side as a result and continued to worsen as the trading day progressed.
 
The few economic reports that came out this week were some big ones for the economy. New housing starts came in at 324,000, well below the 360,000 that economists' predicted. New home sales were down 0.6% month-over-month compared to an anticipated 2.3%.
 
Jobless claims also pushed higher, up 627,000 for a total of 6.7 million. The number was far worse than expected.
 
Finally, the FOMC left interest rates unchanged at 0.0% and 0.25%. The committee did state that there was a slowdown in economic contraction. However, they also noted that due to the poor economy, interest rates could stay at historically low levels for an extended period of time.
 
"Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability," the Fed statement said, adding that inflation is expected "to remain subdued for some time."
 
As for the technical side of things the major market benchmarks are all in a short-term neutral state which means that based on the oversold/overbought model there is not an advantage either way. Given that we have pushed well into the summer doldrums we should expect to see a range bound market going forward with some decent volatility throughout the summer months. This type of price action should bode well for theta-driven strategies.

Overbought/Sold Condition Report

Overbought/Oversold as of June 26, 2009

Major Benchmarks

• S&P 500 (SPY) - 56.6 (neutral)
• Dow Jones (DIA) - 64.5 (neutral)
• Russell 2000 (IWM) -  59.7 (neutral)
• NASDAQ 100 (QQQQ) - 45.4 (neutral)

Testimonial of the week

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