I don't believe that there is any reliable way to determine the "value" of a contract unless it has some intrinsic value, in other words, it has to be in the money. I have used Black-Scholes, etc. and they work ok for i.t.m contracts but they suck for o.t.m. Way too many times I have been absolutely correct on the stock movement and lost on the options anyway. Anybody have a contrary opinion that they can back up with a link or a formula or something ?
I think this is the $64,000 question in all honesty...Depending on which market you are referring to, the skew of OTM options is always there, especially in the stock index options...Obviously the market has a more realistic opinion of how and where the market can trade outside of the standard trading model(B-S)... There is a website(www.wilmott.com) with a slew of quants, PhD's etc that discuss and throw around ideas for different methods for valuing options...A word of caution, this place will really test your grey matter, not for the unititiated!!!...
thanks for the link. Unfortunately I have been "initiated" to the world of otm options by taking losses this year I am sticking with in the money only for the rest of the year, or until i understand all this quant stuff, which ever comes first ( odds are on sticking with in the money )
We went through a lot of this with the Nassim Taleb/Victor Neiderhofer thread a few months ago. Most options traders view OTM's as sucker plays that are good only for selling. Taleb takes the contrary view on the ground that B-S model undervalues the "tails" of the distribution, ie the OTM's. The problem is they are undervalued only in the case of extreme events that by definition occur so infrequently that they are tough to trade.
Right, and that was an interesting thread... The only issue I have with either Taleb or Niederhoffer is that, if one were to take their "soundbites" at face value, one would be led to believe that its an "either/or" situation...But, as we all know, it is never that way with options...There are just as many ways to profit from volatility extremes(both on the high end and the low end)...You just need an arsenal of strategies for both situations... I also think this is very market specific...With index options, you can get a heck of alot of vega loading and compressing in a short period of time...With certain equity options, you can get the same...The tabletop is very important as well as it pertains to how much move you can get on the "tails"...
I think what Taleb says is not that the model undervalues OTM options. I believe that Black-Scholes is only really relevant ATM and that the principal source of valuation for OTM options is the market itself (either through statistical modelling or just looking at the current quotes). Taleb's point is that there is a tendency for people to want to make money a small drip drip way that you would do selling OTM options. If enough people do this those OTM option prices no longer reflect the genuine but rare risk of huge moves against your position that wipe you out. So in some sense OTM options will tend to become relatively cheap after the previous panic move has subsided from memory because it will appear like you are making "free" money - all those "expensive" OTM options: "who are the suckers who buy them?" After a huge move has not happened for a long time these option sellers will have made lots of easy money and will no doubt have reflected their "success" in their position sizing...=> ouch! The OTM option buyer (Taleb) on the other hand waits. He buys and buys and buys over time. He leaks money every day because of the option time decay. But every now and again he hits the jackpot. Difficult psychologically to lose money for perhaps months at a time but then suddenly make it all back and more in a few days/weeks. Either side can do well though as long they both wait for situations where OTM might genuinely be relatively cheap or expensive...you just have to know when that is... Q1
Hi, Maybe the problem is that you have choosen wrong series or strike for OTM. You have to know that it is enough difficult to select right OTM fot trading. best regards
I agree with the drip-drip method of making money. I don't believe it is wise to attempt to make money from buying OTM options and I have heard of some making money like Taleb for a while. Of course, the selling of OTMs can be lucrative as well with the same consequences. IMO, you must match the transaction to the market and the relative movements that are occurring. In 98-00, huge swings were commonplace so buying OTMs were more profitable (relatively speaking) because the premiums often failed to reflect the potential movement. Today, the opposite is true and selling tends to be more profitable (more consistently) due to the lack of home runs to the upside.
I just posted this over at Wilmott. Those guys couldn't agree on an answer. I suspect that while their answers our likely more theoretically correct the good folks at elitetrader might be able to give me a bit more robust and useful. "I have been following this thread with great interest. I am an intraday futures trader who is usually more concerned with the tick by tick movements of the market than the lofty nuances of pricing theory but I have been wondering as of late how to transfer the option prices I see into probabilities or odds. I have a challenge for you folks seeing that there is some disagreement as to how to go about this. I would like to know what the market agrees upon as the odds of JPM falling to a price below $10 by December expiration. Here are the variables: S = 18.5 X = 10 T = 0.3333 r = 2.00% V = 83.7% d1 = 1.5289 d2 = 1.0459 N(-d1) = 0.06313975 N(-d2) = 0.14779857 Put Value = 0.30 I would imagine that the odds are relatively high seing that JPM has been getting some very negative press lately with the outlying chance of their total collapse appearing greater than normal. Please excuse my ignorance if any of this is glaringly incorrect. I am still learning and this looks like the place to do it." The big debate was if the probability was closer to N(-d1) or N(-d2) and how this was in relation to volatility smiles and risk neutral probabilities. Interesting stuff but not a directly applicable answer.