OPTIONS
Exploring Possible Futures, Assessing Realistic Results
Persistent Option Volatility
by Roger Ison, Ph.D.
Do you really understand what your options model is doing? Let's find out.If you trade options, you know that mathematical option models are essential tools and, generally, very good. Market makers rely on option models explicitly; for example, at least one well-known broker provides tight, mechanically derived, online bid and ask prices for any option, and usually executes trades at their model prices instantly, without human intervention. Brokers' models can be quite sophisticated, taking into account factors other than the theoretical price, such as the market maker's current "book," quotes on other markets, anticipated dividends, recent volatility, and the cost of hedging the market maker's position with other options or futures.
ANALYZING YOUR MODEL
It's a bad idea to trade against that sort of computational firepower without a decent evaluation of the current option prices. It's also a bad idea to trade without having a clear sense of how your strategy might unfold over time. Excellent modeling software is available to traders, and some usable tools are accessible by web browser, but there are some mistakes traders may make when interpreting these models. In this article, we'll explore the issue of persistent volatility.
An option is a bet on the future, so in addition to option prices, the trader ought to evaluate strategic questions, such as:
Good modeling software can give reasonable answers to questions like these. The answers depend greatly upon volatility, one of the five parameters (variables) that are used as input values to option pricing formulas. Volatility is a statistic that measures the amount of daily variability in a stock's price, independent of any trend that may be taking place. It's really a measurement of the underlying stock or index, but sometimes it is useful to treat options as if they had a volatility characteristic of their own that is to some extent independent of the stock's actual price behavior.
- How likely is this trade to be profitable?
- At what stock prices will it be profitable?
- In the worst-case scenario, or under various, possible, future conditions, how much can I lose?
- How long must I hold the stock to stand a decent chance of making money?
- After some time has passed and the situation has changed, should I take my money and run? Or hold on?
...Continued in the August issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the August 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
Return to August 2005 Contents