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.
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.
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.
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Terry
April was another outstanding month for the bulls. The Russell 2000 (IWM) and Nasdaq 100 (QQQ) have pushed to all-time highs. The S&P (SPY) and Dow (DIA) are quickly moving in that direction.
All is well on Wall Street. Or is it?
The timing is perfect for the old Wall Street adage, "sell in May and go away". Read my article from last week for more info on the seasonal tendencies that typically occur during the "summer doldrums".
The market is frothy over every time frame - short, intermediate and long-term. According to my overbought/oversold indicators the major market benchmarks have all pushed into extreme overbought territory over the short-term. Typically, when this type of reading occurs among all of the benchmarks we will see at least a short-term reprieve over the next 1-3 days.
Moreover, almost every indicator I follow has pushed into bearish territory. One that recently caught my attention was the survey from the National Association of Active Investment Managers (NAAIM). The survey currently reads the same as the prior week, but what is noteworthy is that there were no active managers that were net short. The most bearish active manager was flat. The most bullish manager - 200 percent long. The survey has never witnessed such a discrepancy between the bulls and the bears. Typically this acts as a contrarian reading, so we shall see if this plays out as planned over the next few weeks.
Another interesting indicator that came to my attention is the Nasdaq closing TICK. The TICK for the Nasdaq is currently in historical overbought territory over several time frames. This type of reading has occurred six times since 2000 and each time the tech-heavy index has taken a one to two week reprieve going forward.
As for economic news, first quarter GDP climbed at a seasonally adjusted annual rate of 1.8 percent. The low number was attributed to an increase in imports, a slowdown in personal spending and a decline in federal government sending.
Big Ben's historic press conference was basically a reiteration of everything that has been stated in the past. So nothing new there. The FOMC left rates unchanged and actually trimmed its 2011 growth forecast. However, the Federal Reserve did lower its forecast for unemployment in 2011 to a range of 8.4 percent to 8.7 percent.
The next few weeks should be very interesting. The summer in general should be very interesting. I truly think that we will see a decline followed by range-bound trading. This should bode well for premium selling strategies like the ones that Terry employs.
Andy
I would like to express my satisfaction with your portfolios. My performance far surpasses anything I've ever done in stocks, mutual funds and (don't remind me), investment real estate. I'm definitely planning to increase my capital allocation. I also thank you for your recommendation of thinkorswim. They are a first rate outfit. -- Brad