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Option Master Chapter 1
Download the Option Master Manual - PDF 187k

 

Software for Pricing Options
by Kenneth R. Trester
and Robert P. Swanson


Chapter 1 - Introduction


OPTION MASTER®: Your Bluebook to the Options Markets

OPTION MASTER® is designed to help you determine whether a stock, index or futures option is fairly priced, and to determine whether an option is over- or underpriced. Similar to the purpose of the "blue book" that is utilized in the used car market, OPTION MASTER® is designed to tell you what the fair price of an option should be in a quick and easy manner.

OPTION MASTER® allows you to select the best option for a stock, commodity or index such as the S & P 100 Index, and does this by evaluating all of the options for that index, determining what their fair price should be. Unlike other option pricing programs, there is no need in this program for accessing an expensive data base, incurring high telephone charges, or buying additional hardware. Just a few easy entries into OPTION MASTER® will allow you to determine the fair price for a whole set of options. OPTION MASTER® is so easy to use that within a few minutes you can easily evaluate all the options for a whole series of stocks, indexes or commodities.

Options Defined

For option novices, much of the confusion regarding options can be removed if you look at listed options as side bets. Call options are side bets that the underlying common stock (index or futures) will rise in price above the strike price; put options are side bets that the underlying instrument will fall in price below the strike price.

These side bets have time limits of a few days to several years. The price you pay for this bet is determined on the option exchanges, and the price changes from moment to moment during the trading day. The price you pay for a put or a call is usually determined by the time left in the option (the expiration date), and how close the underlying stock price is to the strike price.

For example, a Ford Motors March 40 call is an option that expires on the third Friday in March. This option's strike price is 40. Each option is for 100 shares of stock, so if this option is priced at 1/2 (or .50), it is really priced at $50 (.50 X 100 = $50). Options that are not past the strike price are out-of-the-money.

The price you pay for out-of-the-money options is purely the anticipated value of the option. In other words, this price is an anticipation of the real in-the-money (or into the strike price) worth of the option at expiration. If the underlying stock price does not move through the strike price before the expiration date, the option will have no value.

For each point that the underlying stock price is in-the-money, the option is worth $100 more. For example, if Ford Motors is priced at 44, a Ford Motors 40 call in March before expiration would be worth at least $400. When there is little time left before an option expires, the anticipated value (or time value) of the option is quite small. Here, out-of-the-money puts and calls will have cheap price tags. In other words, you can make a small investment, with a chance to make a large profit.

The Importance of Option Pricing

The most important key to success in the options market is not picking the right stock, but paying the right price for an option when you buy one, or when you write (sell) an option. Almost all market makers on the option exchanges and most option professionals are using option pricing models like OPTION MASTER® all the time to determine whether options are underpriced or overpriced according to such pricing models.

Now, with OPTION MASTER®, you have the same advantage that the professionals have. The pricing of options is so important because when you pay too much for an option -- even if the underlying stock or commodity futures price on which that option is purchased moves in the right direction -- you probably will not get enough reward for your potential risk. In a sense, you have stacked the odds against yourself. On the other side of the coin, when you buy underpriced options, you will get far more rewards compared to your risks when the underlying stock, index or commodity moves in the right direction. Now you have stacked the odds in your favor.

The goal of all option investors should always be to buy only options that are fairly priced -- and better yet -- underpriced according to a pricing model such as OPTION MASTER®. (Investors who write options should always attempt to write options that are overpriced, where they will receive more premium than the fair price of the option.)

Always remember: when you buy overpriced options, you stack the odds against you, but when you buy underpriced options, you stack the odds in your favor.

The Determinants of the Option Price

There are several factors that determine what the option price will be and how the option price will change. These include the following:

  1. The underlying stock, index or futures price.
  2. The strike price.
  3. The volatility of the underlying stock or futures price.
  4. The time left until the expiration date of the option.
  5. The short-term interest rate.

These five factors are the key determinants of the price of an option, and most of this information can be found in most major daily newspapers, except for measurement of price volatility. However, we have a special section in OPTION MASTER® for measuring volatility quite easily using the data that is available in the daily newspaper. Therefore, with your newspaper in hand, you can easily determine the fair price (true worth) of most options quickly.

Where To Start

Most investors approach the options markets by first finding a stock or commodity that they think is ready to move, and then look to the options market to pick an option. However, if you prefer to play the market as a whole, when you think the stock market is going to move up, you can choose an index, such as the S & P 100 (OEX) Index, and then select a call option on that index, hoping to participate if the whole market moves up in price.

Here your goal should be to select the best priced option that is available for the underlying stock, index or commodity that you like, and if all the options are overpriced, you should pass, and move on.

Option writers should be doing the opposite. If they want to write (sell) options, they should try to select the most overpriced options, and they should pass up stocks or commodities where all the options are underpriced.

Another approach to the options market that is a little bit unorthodox -- rather than picking the stocks, commodities or futures in the market and then looking at their options, first try to find the most underpriced options by using OPTION MASTER®, and then from there, select the best stock or commodity. In this instance, by choosing underpriced options, you have stacked the odds in your favor to begin with, and now all you have to do is to identify an underlying instrument that has a good probability of moving in the right direction.


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