Weekly Stock Options Trading Tips: July 6, 2009

Stock Options Trading Idea of the Week

Option Pricing and the Black-Scholes Model

This week we will continue our discussion of how options are valued.  I hope you had a great Independence Day weekend.

Terry

Option Pricing and the Black-Scholes Model

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.)

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 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.
 
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 Idea 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 attempt to improve weaknesses in the basic model 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.
 
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 holiday shortened week was filled with a few key less than stellar economic reports, namely consumer confidence and the closely watched unemployment report. Corporate news was slim so market participants turned their attention to the two aforementioned reports and unfortunately were not thrilled by the outcome.
 
Consumer confidence came out Wednesday with a decline of 5.5 points to 49.3. The decline shows a waning of public support regarding the current state of the economy.
 
Consumer confidence readings above 50 signal expanding optimism among U.S. consumers, whose purchases constitute more than two-thirds of gross domestic product. A reading below 50 would tend to be bearish for stocks and it was certainly a disappointment to see a report that was came in slightly under 50 after an above-50 one the month prior. The current reading effectively undermined the recent consensus that major economic yardsticks are due to level off and then gradually improve in the months ahead.
 
"That kind of news is all you really need to get the market down in the sort of environment we're in," said Art Hogan of Jeffries and Co.. "You don't have a lot of conviction in this market, so there's really not much underpinning for a rally to begin with."
 
"A lot of people are looking for some consolidation in this market," with many analysts calling for a 10% pullback that fits the traditional definition of a bull-market correction, said Jim Paulsen of Wells Capital Management. "But it's possible that we could also be seeing consolidation just through the passage of time."
 
On Thursday the U.S. Department of Labor announced that non-farm payroll employment continued to decline in June. Nonfarm payrolls fell by 467,000, which was worse than the expected decline of 325,000. Overall, the unemployment rate rose to 9.5% from 9.4% in June. If another 900,000 jobs disappear by the end of the year which is highly likely, an entire decade of employment gains will have been wiped out.
 
"On the whole, this was a very ugly labor market report, and there is no amount of lipstick that can improve its image," says Millan Mulraine, an economist for TD Securities, in a note reacting to the report. "Indeed, not only does it suggest that the pace of job losses in the U.S. remains very high, it bucks the trend of four consecutive months of improvement in the pace of job losses."
 
Looking ahead to next week, earnings reports are extremely light next week, but Dow component Alcoa (AA) marks the start of earnings reporting season Wednesday. This should provide the start of some directional movement within the major market benchmarks over the next few weeks.
 
As for the technical side of things the major market benchmarks are all near a short-term oversold state which means that based on the oversold/overbought model we should see a short-term tick to the upside over the next few trading sessions. As I stated last week, given that the market has pushed well into the summer doldrums we should expect to see a range bound market going forward with some decent volatility, particularly now that we are entering third quarter earnings season. Again, this type of price action should bode well for theta-driven strategies.

Overbought/Sold Condition Report

Overbought/Oversold as of July 3, 2009

Major Benchmarks

• S&P 500 (SPY) - 32.1 (neutral)
  
• Dow Jones (DIA) - 31.2 (neutral)
  
• Russell 2000 (IWM) -  37.3 (neutral)
  
• NASDAQ 100 (QQQQ) - 33.8 (neutral)

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