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Option Master Chapter 3
Download the Option Master Manual - PDF 187k

 

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


Chapter 3 - Using OPTION MASTER®


Quick and Easy

The OPTION MASTER® computer program is designed to quickly price options for you with few entries, and it is designed for great ease in use. After fifteen to thirty minutes of practice, you will discover OPTION MASTER® to be easy-to-use and understand and you probably will rarely have to resort to reading this manual after a few sessions of practice.

The goal of our program is to allow you to enter the fewest key strokes possible so that you can quickly price many options within a short period of time, or determine your probability of profit when you buy or sell an option or enter an option strategy.

In addition, there is a volatility calculation so that you can calculate the price volatility for the underlying stock, index or commodity futures contract, which is one of the required inputs in this program.

A Practice Session

To demonstrate the features of OPTION MASTER®, we will walk through several examples using the different features of OPTION MASTER®. The figures used are from OPTION MASTER® for Windows/TM. OPTION MASTER® for DOS is identical to OPTION MASTER® for Windows/TM, except for slight differences in graphics. The current version of OPTION MASTER® for Macintosh® also operates in a similar fashion to OPTION MASTER® for Windows/TM, but does not include all of the OPTION MASTER® for Windows/TM features.

Pricing An Option
Let's assume that you wish to determine the fair Theoretical Value for a call option on a specific stock, such as IBM, in this case, the IBM September 110 call, with IBM priced at 105 3/8, with the present date being August 5, 1995. For a single stock or index price, go to the menu item, "Single Option Price." You can do this by clicking on Calculate, then Prices and finally Single Option Price. There are six entries that are required:

  1. Beginning Date (today's date)
  2. Expiration Month
  3. Stock Price (stock or index price)
  4. Strike Price
  5. Volatility
  6. Interest Rate (3-month Treasury Bill rate)

The Beginning Date is usually today's date, and your computer should default automatically to that date. Now, using the tab key, move to Expiration Month. You can select the month by clicking on the "arrow" or using the arrow keys, or by just typing the first letter of the month.

Now move to the Stock Price entry box using the tab key. Enter the IBM stock price, 105 3/8. You may use the decimal instead of a fraction if you wish (i.e., 105.37). Now move to the Strike Price entry box and enter the strike price of 110.

Next, tab to the Volatility entry box. Volatility (the amount the price will move up or down within a specific time span) refers to the historical price volatility of the underlying stock, index or commodity. OPTION MASTER® will calculate the Historical Volatility in the Volatility menu item of the program (refer to Chapter 4).

As a rule of thumb, you can enter .30 for a stock with average price volatility, .20 for a stock with low price volatility, and .45 for a stock with high price volatility.

Broad-based indexes have price volatilities that range from .07 to .15. These volatilities are quoted in percents, so .07 is 7%.

Commodity and other futures contracts vary dramatically. For example, Treasury Bonds usually have a volatility of around 8%. Currencies usually have volatilities from 5% to 13%. Treasury Bills or Eurodollars have a volatility of between 1% and 2%. The volatility for grains usually ranges from 10% to 40%, pork bellies 30% to 40%, gold 10% to 20%, silver 20% to 30%. (Refer to Chapter 4 for typical volatilities.)

With our IBM example, we use a volatility of 30%, or .30. The program always defaults to this volatility.

Finally, using the Tab key, move to the Interest Rate entry box and enter the 3-month Treasury Bill rate, or the prevailing short-term interest rate (i.e., 5% = .05).

Now you are ready to calculate the fair Theoretical Price for the IBM September 110 call. Just click on the Call Prices box and the results will be displayed in the Message Center. (Refer to Figure 2)

As you can see, the Theoretical Call Price is 2 5/8. Your Probability of Profit, if you purchased this option at its theoretical price, is 26% if held until expiration. If you are an option writer, your Probability of Profit would be the inverse of this figure. In other words, you subtract the 26% from 100%, giving you a Probability of Profit of 74% (100 - 26 = 74).

OPTION MASTER® also displays the Delta, Gamma, Theta and Vega that are defined in Chapter 2. Once you have the theoretical price for an option, you can compare it to the actual price in the market through the newspaper, your quote system, or your broker.

Pricing Several Options

Now let's say that you want to determine the theoretical price for a whole group of options for three expiration months. Let's use the S & P 500 Index (SPX) options in this example with the SPX at 559.02 and a volatility of 11%.

First click on Calculate, then select Prices and then select Multiple Option Prices. On the Multiple Stock & Index Option Prices screen, Beginning Date is again today's date, here August 5, 1995. Clicking on the arrow next to the Expiration Cycle gives you the choice of "every month" -- the next three months, or the months in the January expiration cycle, the February expiration cycle, or the March expiration cycle. We will select Every Month. Next to Stock Price, enter the S & P 500 Index price of 559.06. The Beginning Strike Price requires the lowest strike price that you want to determine option value. Enter 540 in this entry box. Tab to Ending Strike Price and using the arrow key, select a strike price of 575 -- the highest strike price on which you wish to price options. Tab to Volatility and enter .11. Then tab to Interest Rate and enter .05. Always make sure to tab out of an entry box before doing a calculation.

Now by clicking on Put Prices (or Call Prices), you receive a whole range of theoretical option prices. (Refer to Figure 3 and Figure 4)

This table of theoretical index put option prices in Figure 4 can then be printed for future reference.

Calculating Futures Options Prices

Entries to determine the theoretical price for a commodity option differ in several aspects from pricing stock options. First, you must enter the exact date that the futures option expires.

The options on a specific commodity expire at a different time in the month than other commodity options, usually in the previous month to the futures contract. You can obtain a calendar that spells out the expiration date for each set of futures options from your commodity broker. Such a calendar is also published in Futures magazine.

When entering the futures price and strike price, make sure to follow the example that accompanies the computer prompts. When entering grain prices such as wheat, corn or soybeans, enter the price as cents, rather than dollars and cents. For example, if September wheat is priced at $4.01 a bushel, enter 401 -- not 4.01. When entering prices for other commodities such as hogs or cattle, enter the cents per pound as a whole number. For example, if September hogs are priced at 49.23¢, enter the price as 49.23, not .4923. Currencies would also be entered as whole numbers for cents. For example, if the Japanese Yen is priced at .6824 per 100 Yen, enter 68.24 -- do not enter .6824.

When entering strike prices, follow the same format and be consistent. If you enter 400 for the futures price and 4.00 for the strike price, the theoretical option price would be way out-of-line. Therefore, rather than give you a faulty price, the program gives you an error message.

Entering bond prices is different than other futures contracts. You enter bond prices in points and 32nds. Therefore, to enter 90 18/32, you would enter 90 18/32 or 90.18. OPTION MASTER® converts the 90.18 into 90 18/32 automatically.

Another Practice Session

Let's determine the fair theoretical value of the Soybean November 650 call on August 3, 1995, with the Soybeans November futures contract priced at 608.5. First click Calculate, then select Prices. Then select Grains under the heading Commodity Option Prices.

The Beginning Date is again today's date. Tab to Expiration Date and type in the expiration date, which in this case is October 20, 1995. Again, to select the month, tab to it and just type in the first letter of the month or use the arrow key.

Now tab to the Futures Price and enter 608.5. Tab to Strike Price and enter 650. Tab to Volatility and enter the historical price volatility for the Soybeans futures contract. (Refer to Chapter 4 to determine volatility.)

Presently, we will use a volatility of 40%, or .40. So enter .40 in the Volatility entry box. Tab to Interest Rate and enter the 3-month Treasury Bill rate (i.e., .05 for 5%). Then tab out of this box. Always tab out of an entry box where you have made a change before activating a calculation. Now you are ready to calculate the theoretical price of the Soybeans call. Click on Call Prices and check the Message Center for the results. (See Figure 5)

As you can see, the theoretical Soybean call price is 28 5/8¢, and your probability of profit of 29%, if you buy the option at its theoretical price and hold until expiration. If you are an option writer, your probability of profit would be the inverse of 29%. In other words, 29% subtracted from 100%, giving you a Probability of Profit of 71% (100 - 29 = 71).

Multiple Futures Options

You can also determine the theoretical price on a whole series of futures options. Let's use Treasury Bonds to demonstrate this feature.

We will determine the theoretical price for a series of options on the September and December Treasury Bond futures contracts. Click on Calculate in the menu bar. Select Prices, and then select Multiple Futures Prices. Tab to Expiration Dates and enter the expiration date for the September Treasury Bond option, and then the December Treasury Bond option. For our example, the September options expires on August 18, the December options expires on November 18. (See Figure 6)

Now tab to the First Futures Price and enter the September Treasury Bond futures price for August 4, 1995 -- 110 25/32. You enter this price as 110.25 and it will convert the decimal to a fraction -- but first click the Bond box below with your mouse.

Now tab to the Second Futures Price and enter the December Treasury Bond futures contract price of 110 9/32, or 110.09.

Now tab to Beginning Strike Price and enter the lowest strike price on which you want to price options. Continue to Ending Strike Price and by using the arrow key, select the highest strike price you wish to use.

Strike prices for bonds are in 2-point increments. Therefore, you must change the increment rate. To do this, click Extras in the top menu bar. Select Configure. Under the category of Multiple Strike Price Increment Value, click Custom and Tab to the entry box and enter the number 2, and click Save.

In Figure 6, we used a low strike price of 100 and a high strike price of 114. Now Tab to Volatility and enter a volatility of 8.5%, or .085. Tab out of Volatility and click Put Prices.

Figure 7 shows the theoretical Put Prices Table generated by this calculation. By clicking on File, you can either print this table or return to the program. As you can see, Treasury Bond options are quoted in points and 64ths.

Other Commodities

When attempting to determine the theoretical value of a futures option other than a grain or bond -- such as gold, silver, copper, the currencies, cattle, hogs, oil, etc. -- select Other Commodities under the Prices menu.

Using Configure
Under the Extras menu in the top menu bar, select the item Configure (see Figure 8). As we saw when pricing Multiple Futures Options, you can change the increment value between strike prices -- with stocks the typical increment is 5 points, but the Option Exchanges are now experimenting with 2 1/2 price increments. So as needed, you can change the increment you will use. In addition, you can decide to display the Delta, Gamma, Vega and Theta every time you price an option by selecting Always. You can also specify the Startup Screen.

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Go to Chapter 4 | Return to Table of Contents


 
 
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