Simple questions... or not so simple?

mind_the_gap · Jan 1, 2009

Happy New Year to everybody!

I've been trading stocks for several years now and I'd like to expand my strategy to options. I'm familiar with the basic theory (greeks, volatility, etc.), but when it comes to actually trading I realise that I haven't understood the "real problems", so here goes:

1. The price of an option seems to be the result of supply and demand, so the "fair value" (Black-Scholes for example) doesn't necessarily have anything to do with what I pay for an option, right?

2. Implied volatility. If the price is dictated by supply and demand, then the implied volatility is actually calculated from the other parameters (strike price, price of the underlying and the option, time until expiration, interest)? If that isn't the case, who gets to decide what the implied volatility for an option will be?

3. If you buy an option, how do you make sure you're not paying too much for it? How are you using Stop Loss orders with options? Does it make sense to use them with options at all?

Thanks for your answers,

MTG

jwcapital · Jan 1, 2009

Quote from mind_the_gap:

Happy New Year to everybody!

I've been trading stocks for several years now and I'd like to expand my strategy to options. I'm familiar with the basic theory (greeks, volatility, etc.), but when it comes to actually trading I realise that I haven't understood the "real problems", so here goes:

1. The price of an option seems to be the result of supply and demand, so the "fair value" (Black-Scholes for example) doesn't necessarily have anything to do with what I pay for an option, right?

2. Implied volatility. If the price is dictated by supply and demand, then the implied volatility is actually calculated from the other parameters (strike price, price of the underlying and the option, time until expiration, interest)? If that isn't the case, who gets to decide what the implied volatility for an option will be?

3. If you buy an option, how do you make sure you're not paying too much for it? How are you using Stop Loss orders with options? Does it make sense to use them with options at all?

I suggest you do some reading about basic option strategy, for until then, the answers to your questions are moot.

1. This is basically true. If you look at the bid/ask spread for options, fair value is generally half-way between. Option pricing is very efficient, except that the market makers want to make a profit too, so spreads can be wide. It is foolish these days to hit the bid when selling and hit the ask when buying. You gotta "negotiate" by placing limit bids in between the bid/ask spread.

2. Option pricing is multi-dimensional (time, volatility, direction, delta (velocity of change, if you will), and gamma (acceleration of change, if you will). The market makers efficient calculate the bid/ask. It is your job to negotiate. In general, in high volatility situations, options tend to be overpriced. But again, that is just looking at a single dimension. Read up on the Greeks and how various strategies attempt to take advantages of certain situations.

3. Not to be redundant, but you gotta negotiate the price. Regarding stop losses, it depends on the strategy. Obviously, buy an option, your loss is limited to the premium paid. Again, all this depends on the selected strategy.
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dagnyt · Jan 1, 2009

Quote from mind_the_gap:

1. The price of an option seems to be the result of supply and demand, so the "fair value" (Black-Scholes for example) doesn't necessarily have anything to do with what I pay for an option, right?

No. The professional market makers use computers to establish the prices they are willing to pay (bid) and sell (ask) options. That is based on the B-S (or other) equation.

Supply and demand may move the starting price, but the price is based on the model.

2. Implied volatility. If the price is dictated by supply and demand, then the implied volatility is actually calculated from the other parameters (strike price, price of the underlying and the option, time until expiration, interest)? If that isn't the case, who gets to decide what the implied volatility for an option will be?

No one decides. The price of the option 'tells' you what the implied volatility is. As the market price of the option changes, so does the IV change. You take the option price, substitute it in your B-S equation, and calculate the IV.

3. If you buy an option, how do you make sure you're not paying too much for it?

The short (inaccurate reply) is to say: don't pay a higher IV than the average IV for the stock. But that's no good.

In today's world, IV is much higher than it has been through the years (although much less than the past few months).

The IV is an ESTIMATE of how volatile the stock is going to be in the FUTURE, specifically from now through expiration. So, if you pay LESS than the future volatility turns out to be, you got a bargain. If you pay more, you paid too much.

It's tough to know future volatility, so all you can do is estimate it. And, there is no reason to believe you can do a good job predicting. That makes it difficult to know if your price is too high or too low. The point for you is to avoid paying much higher than recent volatility of the stock and avoid selling much lower.

Not a simple task.

How are you using Stop Loss orders with options? Does it make sense to use them with options at all?

It does NOT make sense to use stop loss with options. First, time decay drops the option price slowly but steadily. Second, a sudden change in IV can result in your stop being hit. If you do use a stop loss, base it on the underlying stock price, not the option price.

Thanks for your answers,

One piece of advice: It's VERY difficult to make money when buying options. It's also very risky to sell naked options. Consider learning about spreads.

MTG
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Mark
http://blog.mdwoptions.com/options_for_rookies/

spindr0 · Jan 2, 2009

This isn't going to answer your questions but here goes anyway...

I started as an investor a lonnnnnng time ago and ventured into serious day trading 6-7 years ago, trading on the news of the day as well quarterly earnings. Early on it was mostly stocks and eventually it became mostly options, particularly for earnings.

Outside of being very selective for specific options earnings plays, I now trade mostly stocks. The main reason is that options have so many things to get right (IV change, skew, time decay, wider spreads, liquidity and direction) whereas with stocks you just have to get the direction right.

So my 2 cents is learn options but concentrate on what works best for you.

mind_the_gap · Jan 2, 2009

Quote from jwcapital:
3. Not to be redundant, but you gotta negotiate the price. Regarding stop losses, it depends on the strategy. Obviously, buy an option, your loss is limited to the premium paid. Again, all this depends on the selected strategy.
More...

Thanks, your post made options a lot clearer for me!

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Simple questions... or not so simple?

mind_the_gap

jwcapital

dagnyt

spindr0

mind_the_gap