Help with option theory

Discussion in 'Options' started by jasonc, Sep 21, 2008.

  1. jasonc


    I was wondering if the members of this board would mind critiquing the following logic about a options trade.

    I decided to evaluate a hypothetical trade of doing a covered call on Microsoft stock. I used fridays closing price then the ask price for the various call options i wanted to trade.

    Alright so what i did was look at the various price that Microsoft Jan09 calls were trading at from $22.5, $24, $25, $26, $27.

    After finding the premiums for the various contracts i then used excel to calculate the profit or loss if i bought 100 shares of Microsoft stock and then sold 1 call. After figuring out this profit for microsoft stock if the price of microsoft varied from 27-22.5 a share.

    I then calculate the standard deviation of Microsofts stock price ($1.25) and then figured out the probability that microsoft stock would finish at 27, 26, 25, 24, and 22.5. after I got these numbers i calculated the Expected value of each one of these places the stock could finish and then summed up those values to find the EV of the overall trade.

    i calculated the EV for selling a 27 call, 26 call, 25 call, 24 call and the 22.50 call. Then the trade with the highest EV would be the best trade, right? Also how does this logic sound?
    One more question is how would i do the math so it would be more specific since currently i was only able to do the math if the stock traded at exactly 27, 26 etc. instead of 26.48 or something like that.

    Thanks for any comments and help


    PS. based on my calculations of the best trade it would have a EV of 142.44 over 4 months which is a 6.4% return
  2. Hi Jason

    Which one, from which period?

    How did you do that ?
  3. This is my critique, hope it helps.

  4. dmo


    If that's the approach to option trading you want to take, it seems to me that a much simpler shortcut would be to simply buy the option with the lowest implied volatility.

    Let's say you have 3 options on MSFT.

    Option 1 has an IV of 27%
    Option 2 has an IV of 29%
    Option 3 has an IV of 31%

    From a statistical point of view, the purchase of any of these options is a bet on the future volatility of MSFT. So option 1 is fairly priced if MSFT ends up having actual volatility of 27% from now until expiration. Option 2 is fairly priced if MSFT has volatility of 29% from now until expiration. Option 3 is fairly priced if MSFT has volatility of 31% from now until expiration.

    Since all 3 options are a bet on the same thing - the future volatility of MSFT - then obviously from a statistical point of view, option 1 is the cheapest, and should have the best relative return.