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:
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.
In future newsletters, we'll continue this discussion of volatility and why it is the most important variable in option pricing.
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Terry
Once again, the market continued its winning streak in the face of poor economic reports this past week. It marked the third consecutive week of gains which has not occurred since 4/23 when the Dow was in the midst of an 8-week rally. Indeed, the week was quite bullish with several failed bearish attempts scattered throughout the week. Each time a poor economic report hit the wire, the bears pushed the market decisively lower only to have the bulls come in later and push the market right back to where the selling began. If you were leaning towards the bearish camp, you were certainly frustrated by the price action by the end of the week.
The Dow, S&P and Nasdaq finished the week higher 1.8%, 1.8% and 1.5%, respectively. All three major indexes are now in positive territory for the year.
Furthermore, the CBOE volatility index, widely considered the best fear gauge of fear in the market, fell over 7% to nearly 22.
The week and month started off with a large gap to the upside and traded in a fairly tight range near the high until Friday's much anticipated jobs report was reported. Both the S&P and Nasdaq 100 hit resistance early Monday, which happened to be at the 100-day moving average. Both indices were unable to push through the resistance all week as volume waned (conviction). As I mentioned before, the indices were swayed intraday by poor economic reports, but the swings to the downside were not enough to close the gap from Monday.
Much of the week was geared towards the jobs report that was due out Friday. In the end, employers in the U.S. cut 131,000 jobs from nonfarm payrolls in July and June payrolls were revised to show 221,000 jobs were lost that month, which was nearly twice the original estimate. Economists had expected to see payrolls drop by 65,000 in July.
"The perception that there is job growth and an economic recovery is underway appears to be a myth," said Todd Schoenberger, managing director at LandColt Trading.
"The foundation for employment growth occurs in promising consumer sentiment and confidence readings - both of which continue to be frighteningly low," Schoenberger said. "Today's number does not initiate a Fed policy move, but the overall trend does."
The weak employment report sent Treasury prices higher, pushing the yield on the 10-year to 2.826%, the lowest yield since the April 15, 2009.
The market fell as a result of the poor unemployment numbers, but as I stated earlier, it was just a bearish tease. Buyers stepped in towards the latter part of the trading session and pushed the market almost to break-even by the end of the day. However, even with the short-term bullishness the probability of a short-term pullback remains high.
There are a few reasons why I think the bears will push the market lower over the short-term. First, historically, when the S&P opens below the prior day's low on a bad miss in the Payroll report, it suffers even more on Monday. Also, the S&P (SPY) has yet to fill the gap from Monday which should weigh heavily on the market while it is near important resistance levels.
Next week brings a few key economic reports, but the one event that everyone will be watching is the FOMC meeting which occurs on Tuesday. This should be a market mover so pay close attention.
Andy
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