I am having trouble understanding the pricing of options. I feel dumb that I have to ask this but I am anyway cause I just don't get it. I trade options from time to time and I understand the way the greeks work and effect prices. I can't tell you anything about the black scholes formula but I get the idea. Can someone please explain in plain english how the greeks can put a price on options at the same time that supply and demand should be doing that? At any point in time the price of a stock or future is supposed to represent all available information causing an equilibrium between buyers and sellers... right? So why can't an option, being that everything is transparent, be automatically priced into the market. For example, why is there a mathmatical formula for theta when as time passes people would naturally pay less for the option thus bringing down the price as it gets closer to expiration?
I'm no options junkie, but there is a mathematical formula(called something like Brownian Equation) that equates option pricing. The four constituents or variables of this formula are 1)stock price. 2) Strike price. 3) Volatility of the stock. 4) Time left till maturity. To answer your questions, options can be seen as 'derivative' of a particular stock in question. It carries more risk and is susceptible to volatility especially with upcoming news or earnings. It anticipates volatility at a far greater rate and its spread could be more subjective when it comes to much thinner stocks.
options will price based on equilibrium between buyers and sellers. If you don't believe me, check out a pharmaceutical stock before fda approval, like DNDN a few weeks ago. The formulas help, but for me I just ask my self what the value of the time is for this specific stock. This implies beta, vega, sega, nintendo, neo geo, etc... when no one is buying or selling, the formula is used.
The greeks don't put a price on an option. They are functions of the instantaneous price of an option observed in the mkt. They also allow you to make an instantaneous forecast about what might happen to the price of the option, if a factor moves in a particular way. The option is automatically priced by the mkt. The formulas simply quantify the intuition behind mkt prices. "Brownian Equation"?
The Greeks do NOT put a price on options nor they affect it. The Greeks are just measures of sensitivity of a particular option to changes in variables that impact the price of an option.
Don't confuse the inputs to BSM with the greeks. The inputs feed into the BSM which spits out the option price. The greeks tell you that if your inputs change by one unit, how the value of your option changes. Theta is not time, but tells you how much the option value changes with time. So in your example in the last sentence the theta is how much the option price is brought down getting one day closer to expiry. So if your option is worth 2, and your theta is -0.3, you know that if you buy it for 2, and if NOTHING ELSE CHANGES BUT TIME, in one day the price will be brought down to 1.7 (all other things being equal and unchanged). You are happy to have that decay of 0.3 because you know that if it goes up you get all of the benefit, and if it goes down it costs you nothing. In the some way the Rho tells you that you have priced the option using a certain interest rate. If rates go up by "1", the value of your option changes by 1 x Rho. So the greeks tell you the sensitivity of your option price to changes in each of the inputs. Hope that made some sense and answered your question??
I agree. I trade liquid options off the charts. It amazing how they respect demand. Check out SPY 100619P119 today. Low was 3.96 which hit the high of 4/27 less a penny. Like you I use a calculator to figure a price for more thinly traded options.
thanks blcdoc. See what I don't understand is that how can something like time decay have a number on it or be measured in the first place. I understand your example but I don't see how a theta of -0.3 can be measured. As time passes and gets closer to expiration, if nothing else changes, time passage will cause buyers and sellers to trade them at lower prices. Naturally its value will reduce with time. But if, like previous posters mentioned, the greeks are a measure of how sensitive an option is to different variables then how can theta determine that an option price, all else equal, should lose 0.3 in value? Does it go by historic prices? Thats the only thing I can think of.