No discussion about option pricing can legitimately be made without mentioning the Black-Scholes model. This model was actually created by Robert C. Merton when he published a paper in 1973 where he coined the term "Black-Scholes" options pricing model and enhancing work that was published by Fischer Black and Myron Scholes. Merton and Scholes received the 1997 Nobel Prize in Economics for this and related work (Black had died before the award was given, although he was mentioned as a contributor by the Swedish academy.)
As we discussed last week, there are 5 components that determine the value of an option:
The Black-Scholes model uses these components to determine the theoretical value of an option. This is the price that, given the 5 inputs, the option "should" be trading at.
The first 4 elements of the Black-Scholes model are precisely measurable in advance of buying an option. The fifth variable, volatility, cannot be precisely measured in advance. True, the historical volatility of the underlying stock can be measured, but that is not the important factor determining option prices. At best, historical volatility is a guide.
What is really important is how volatile the market feels the underlying stock will be going forward. That number is largely psychological, and it is what ultimately determines whether option prices are "high" or "low" or somewhere in between.
Many market professionals base their entire trading strategy on comparing the actual option prices in the market with the theoretical values generated by the Black-Scholes model, hopefully buying "undervalued" (compared to the model) and selling "overvalued" options for the same underlying. If they buy and sell an equal number of options so that they don't care whether the stock goes up or down, they make their money when the market moves the market option prices toward the theoretical prices generated by the model. It is usually a successful tactic, although maintaining a totally neutral option position is quite difficult (and will be discussed in a later Option Trading Ideas of the Week).
Over the years, a number of variations of the Black-Scholes model have been developed, but they are basically minor variations at best, and from my experience, the other models' attempts to improve weaknesses in the basic model come about at the cost of inserting alternative weaknesses into their variation. I have long believed that none of the models do a particularly good job of determining put option prices (the models are much more accurate with call option pricing).
Next week, we'll continue our discussion of the most critical variable in the model - volatility.
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Earnings season is over and now the hard facts of a slowing, U.S. economy have, once again, entered into the minds of Wall Street participants.
The major indexes performance this past week was less than stellar. The Dow, S&P, and Nasdaq lost 3.3%, 3.8% and 5.0%, respectively.
The tech-heavy Nasdaq was hit harder because of a cautious economic outlook from Cisco Systems CEO, John Chambers. Chambers stated, "Things we can control and influence (products and services), we're in great shape," Cisco CEO John Chambers said in a phone interview after the company announced its fourth-quarter results Wednesday afternoon. "On the macro side, (the sputtering economy) there are mixed signals. There is unusual uncertainty."
Ah, there it is the "unusual uncertainty" phrase again. Earlier, in the week, the highly-anticipated FOMC meeting occurred and the statement was somewhat surprising. Even though the initial reaction to the statement was bullish, once the market had time to absorb the entire statement the tone quickly soured.
Federal Reserve Chairman, Ben Bernanke echoed those same words ("unusually uncertain") earlier in the week and also expressed a willingness to take further policy action if needed.
Moreover, the Fed decided to roll over its maturing mortgage bonds into long-term Treasuries, which is an admission by the Fed that the biggest risk to the U.S. economy is deflation.
As you can guess the once the market had time to digest all of the info they would not react kindly. The market gapped lower on Wednesday and again on Thursday. The Dow fell over 400 points during the last four trading days of the week.
Friday's retail numbers just added to the recent bearish fervor. The Commerce Department stated that retail sales increased 0.4% in July which was improvement over the last two months, but unfortunately the number was below economists' forecast. Also, to add insult to injury, the number of first-time applicants for unemployment rose last week.
"We're in a fragile market," said Steven Goldman, chief market strategist, Weeden & Co. in Greenwich, Conn. He noted that the market's decline is feeding the lack of confidence among consumers and investors which inevitably has an impact on the economy.
Interest rates in the Treasury market displayed just how uneasy investors' felt with the recent economic news. Rates, which move in the opposite direction of prices, have tumbled as investors seek out a safe place to sock away their money.
The yield on the Treasury's 10-year note, fell to 2.68% Friday, down from 2.82% one week ago and 2.97% on Aug.2, which was the first trading day of the month.
Technically speaking, the market is entering a seasonally bearish time of year. August and September are two of the three worst performing months in the S&P with the average return in August being 0.0% and September -0.7%. The other is February with an average return -0.02%.
Over the short-term I do expect to see a bounce, which could take us back up to pre-gap levels, but I do feel that any significant bounce will be short-lived. We are still in the summer trading range and until the 1130-1050 area is broken I expect to see more of the same.
Andy
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