More newbee option questions

I'm finding this forum very helpful learning about options and being able to talk to people who understand them better than I do.

I have a couple of questions I wanted to ask...

1) Let's just say stock A was trading at $50, and the market knew the price was going to $70 almost guaranteed. Apart from everybody rushing in to purchase these stocks to make money, if we said all the options were priced correctly, does that mean if the price did move to $70 you wouldn't be able to make any money on options as they were priced correctly?

2) If the above is correct, then does that mean the way to make options is to find ones that are priced incorrectly? ie if the market thinks the price is going down, then the call option premiums would be quite cheap, so buying a lot of these would pay off as when the price goes up you have a nice payday. Or maybe the break even point is $70, but you know it's going to $90, so the price on these options would seem cheap?

3) In essence this is no different from the basic principle of buying standard stock? ie if the market doesn't know where the price is going, but you know it's going up so you can get in before everyone else does and make money. But with options, you know something the others don't, so the price of these options would seem cheap.

4) Options allow you to leverage your money with a margin loan, but you also need to find ones that are priced incorrectly to make money?

5) And then the last question, how do you tell if the option price is favouring bear or bull? ie I think stock A is going to head up, but how do I tell if the option is priced with the market thinking the price will go down, hence it will be cheap for me to buy?

Thanks all

 

The price represents what the market knows. If the market knew the price would be $70, then the price couldn't be $50 to begin with. In other words, it would be a contradiction of rationality to have the price be different than what the traders expect the price to be.

The option price includes the component of time into the value of the stock. The [extrinsic] value of the option comes from the expectation that the underlying could move higher up. In your example, where the market knows for sure that the price would go to $70, the option price would be the strike, minus the spot, plus the extrinsic. The value of the [call] option would be $20 and change. The change, assuming the return is guaranteed, would be extrinsic value. The $20 would be the intrinsic. In other words, there would still be some uncertainty of if the price might go higher or lower after it approaches $70. Thus, there is still some opportunity left.

All the prices are incorrect until expiration. Again, the price represents the uncertainty, which converges until expiration, at certainty. Our best efforts are to estimate the probability of the option value, and compare it to the price. If we feel the value is higher than the price, buy it (and claim the price was incorrect). Remember that in a trade, both sides disagree about the direction the price is going, so all traders think the price is incorrect, but only half of them profit. (Arguably the traders who don't trade do think the options are priced correctly, but then they aren't market participants in this scenario.)

It's pretty different. The time component matters a lot. Being early to a trade is the same as being wrong. If you know for sure the price is going to go up to $70, but it happens a day after your option expires, you still lose. It's another dimension added to the trade.

Options can be converted into stock via put-call parity. There is an arbitrage argument for the pricing of options and stocks where they keep each other in line. I wouldn't say we know something others don't with options, since it's straightforward to convert a port folio of stocks and bonds into equivalent options.

 

#1-This is not a realistic assumption, so it is hard to answer. If I knew 100% that an asset would move from 50 to 70, it would have a vol of 0 since there is no unknown or variance. The difference between today's value and future value would be pure riskless interest.
#2-If I knew that future stock movement would match let say daily average moves of 2% and the options were priced for that, I would not be able to make money buy or selling options if I stayed hedged at all times. If you are unhedged, you can make money if your direction is correct.
#3-If I pick the correct direction, and the stock moves enough to exceed the premiums I pay, I can buy an ITM option with less capital used and have a built-in stop.
#4-Options are not marginable. You have to pay for them in full. The cost of the option is less than the margin on the full stock price.
#5-This is harder and requires making assumptions. When I was an active market maker, I monitored the value of the 25 delta put vs the 25 delta call. Not the absolute difference but how it changes. It shows changes in order flow but might not have any correlation to future stock movement.

 

NO ONE knows what the market is going to do a minute from now, an hour from now, next week, month, year, etc. As Spaghetti Code said if market knew the price would be $70 then it would already be there.

If a stock is at 50 and you think it's going to go to 70 then you can engage any one of a dozen or so call or put options strategies that reflect that sentiment. Long calls, short puts, a strangle or straddle, credit or debit spread, trading options (no pun intended) abound. Others may do the same. On the other hand there may be traders that think the stock will go to 30. And will be trading against you gladly selling a call against your long call. At expiration there will be a winner and loser. But until that day NO ONE will know for sure.

Best

 

If I knew of a stock that was jumping from $50 to $70, I would immediately check out the option's present vol, historical vol (30 day and annual) and the market's VIX. This will tell you whether the option's are cheap, or not.
I like to play, which I still do occasionally, the short side, puts, of things. Empirically the vol spike on big moves south gives me more bang for the buck. But a 50 to 70 jump up should potentially still be a nice hall.
And don't let theta ruin the trade. If you're wrong in a small time frame, accept the bite, take the remaining $'s back and exit.

 

As @Robert Morse noted, you cannot buy options on margin. If the price of an option is $50.00, you have to have $50.00 in your account to buy it. You can't put up a smaller amount and borrow the rest from the broker.

If you have marginable securities in your account (e.g., common stock, bonds, etc.) then you can borrow money against those securities and use the funds to buy options. But the options cannot serve as collateral for a margin loan.

In a nontechnical sense, people often say that options involve leverage, because for relatively tiny amounts of money, e.g., $75 or $750, you can buy an option that is tied to 100 shares of a stock that is, say, $90 a share. So for just $750 you are "gaining control," in an indirect way, of $9000 worth of stock. Some people refer to this as leverage. But it's not margin, and it's not a loan.

In order to trade most of the more interesting option strategies, you have to have a margin account, which means that you have to meet certain criteria for creditworthiness. This is because certain option strategies can result in a loss that is greater than your initial outlay of cash to establish the position (e.g, credit spreads).

BMK

 

Thank you all.

When I spoke about absolutes I know these are not possible but I was trying to hold other variables in the equation constant to understand the impact of certain items.

Let me ask a few new questions which should get to the bottom of what I'm trying to find out.

1) If I have a really good hunch that a stock is going to increase to $900 in 5 days, if the options already have this factored in then the premium + strike at 5 days will be circa $900 and essentially this would just be the break-even point so I couldn't make money on it?

2) So to make money I need to have a hunch about the market and find options that don't currently have this priced in?

3) If the above is correct and I can't make any money on the options, I could still make money by just buying the stock or if I wanted to leverage I could use a margin loan?

Thank you.

 

If you are betting that a stock is going to move up, it is possible to make money in options even if the options are not underpriced, i.e., they may be priced accurately or even overpriced. Whether you make money depends on many different variables. The tough part of it is that even if you are correct that the stock is going up, it has to go up enough, and it has to go up soon enough, i.e., before the expiration date, in order for you to make money.

For example, today it was possible to buy a DIA 315 Feb 22 call for 1.59 ($159). The stock was trading between 310.58 and 311.25.

This call option is out of the money. But you could make money on this option even if the price of the stock never reaches 315. If you buy the call today for 1.59, and tomorrow the price of the stock rises to 314.20, the price of the call will go way up. This is because if the stock goes to 314.20, the probability increases that it will be above 315 on expiration, which is more than a month away.

So you can sell the call well before expiration, and take your profit, and it doesn't matter whether the stock is above the strike price at expiration.

But there are two variables in this example that are very difficult to measure and manage. I said the price of the call will go "way up," but that is a relative term. You can get an idea of how much the price of an option will go up in relation to the price of the stock by looking at the delta, which is a measure of the rate of change. If the option's delta is .25, that means that when the stock goes up one dollar, the price of the option goes up 25 cents (which means $25, because it is tied to 100 shares of stock).

The other variable is how you decide when to close the trade. In this example, I suggested you could make money if the stock goes up--even if it does not reach the strike price--by selling before expiration. But you may be tempted to hold on, because you will make even more money if the stock keeps going up. But if you hold on, it could also go back down.

Determining whether an option is underpriced, overpriced or fairly priced involves using an option pricing model. There is more than one out there. Most involve fairly straightforward formulas, and there are websites where you can play around with an "option pricer," to see how it works. But one of the variables in an option pricing model is the volatility of the underlying stock. Many websites and trading platforms will have a volatility value built into their option pricing model. But it may not be accurate.

There is no single right or wrong answer to the question of how volatile a stock is. There are many different competing theories about how to calculate volatility on a forward-looking basis. You can use historical data to look at how volatile a stock was during the last week, or the last 30 days or the last year. And that may give you an idea, but it is not a foolproof way to predict how much the stock will move in the next 30 days.

If you come up with a model that works, i.e., a "system" that can predict how much a stock is going to move within a certain period of time, regardless of which direction it moves, then you can make money, regardless of whether the stock goes up or down. On this theory, you sell options that are overpriced and you buy options that are underpriced. But you still have to figure out when to get out of the position [LOL].

BMK

 

Buying stock on margin will increase your gains if you are right, and it will increase your losses if you are wrong.

Most successful traders say that beginners should not use margin.

Are you prepared to lose more than the total value of your account?

BMK