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Option Master Chapter 8
Download the Option Master Manual - PDF 187k

 

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


Chapter 8 - The Secret to Success in the Options Game


The Forgotten Secret to Success

In the options game, there is one secret to success -- this secret is followed religiously by the market makers and specialists on the floors of the option exchanges. Yet most investors do not follow this important action. Surprisingly, this simple secret provides an unusual advantage in the options market that is not available in other investment markets.

Unlocking the Secret

The secret to successful investing is always to identify an investment that is priced below its true value. But what is the worth of a share of IBM stock, or one ounce of gold, or a two-bedroom house? Finding assets that are being sold at less than their true worth is a goal of every investor, yet in most cases, the tools to measure true worth are difficult to find, if nonexistent.

Consequently, the majority of investors and analysts fumble with systems for selecting undervalued investments that are founded on superstition and wishful thinking. But the options market is the one place where the tools to scientifically analyze true value exist, and are available to every investor.

The unique nature of listed put and call options enables their true values to be determined by statistical and computer analysis, thus allowing you to spot genuine bargains.

Why Options?

The value of a stock option is dependent on price changes in the underlying common stock against which the option is trading. Naturally, the majority of option investors purchase options based on their assessment of the underlying common stock. Usually investors will, for example, buy calls on stocks that are priced below what they feel is their true value, or when they believe that the common stock price will move up in the present market environment for a variety of prevalent reasons. But the true value of a common stock is hard to determine, although investors are always trying.

Some use systems of fundamental analysis -- studying corporate earnings, net worth, market shares, etc. Others use technical analysis -- studying past price movements.

Evidence indicates that fundamental analysis is helpful only in determining long-term potential movements, but in the short term, a stock's price is influenced by investors' emotions, unpredictable economic conditions, unexpected news events, and other factors that tend to cause the price to move in a random pattern.

If we can assume that short-term stock price moves are truly random -- and the body of statistical and scientific evidence supports this position -- then we have a basis for measuring the real worth of individual options. Nevertheless, investors believe in their ability to predict short-term price movements, and are constantly wagering on their ability to do so. We, of course, believe there are some services and statistical measures that can outperform the random market in the short term, but short-term stock price actions do approach randomness.

Therefore, the intelligent way to invest in the options market is to assume that the market is random in the short term, and make your moves accordingly.

It is the random nature of price movements, coupled with investors' ignorance of this phenomenon, that provides the foundation for locating undervalued or overvalued options on a scientific basis.

Listed options have a very short life. This makes their values highly dependent on short-term random moves in the prices of the underlying stocks. If you are able to determine the degree of volatility of a stock (the average amount the price fluctuates up or down in a given time), and you can assume that the price fluctuations are random, you can apply statistical and computer analysis to determine what the probability is that the price will be higher or lower at some particular time in the future.

With this information, it is then relatively easy to determine the proper price for an option, and to determine whether its present price is too high or too low.

A Matter of Odds

Investors have a hard time understanding the pricing of options. When an investor identifies an option as being underpriced, and later sees that option expire worthless, he then assumes he was wrong, and the option was not underpriced, for it became worthless.

But to understand why an option is underpriced or overpriced, you must understand the laws of probability and odds.

When we say an option is underpriced -- we say in the long run if you buy an option over and over again and hold it for the same exact period of time, your overall result would show a gross profit on that position. Of course, that is only a theoretical profit, because there is no way to buy the same option under the same conditions thousands of times.

But many option players need immediate gratification. If they lose on various options, they begin to think that the price of the option means nothing, and they resort to looking only at the underlying stock or future's prospects, and forget the option's price -- which is a faulty approach to the options market.

Understanding that you can lose in the short term but win in the long term is as simple as flipping a coin. For example, when you flip a coin, you have a 50% chance that the coin will turn up heads. Flip it 10 times, and you might see heads come up only 2 times, or it might even come up 7 or 8 times, rather than 5 times, which are the true odds. When you flip it 1,000 times, however, the probability is that it will turn up heads very close to 500 times. The greater the number of flips, the higher the probability that the results will be 50% heads and 50% tails.

This same phenomenon is true in all situations where random events are concerned, such as the options market. When you buy options that are underpriced, according to the laws of probability, you may lose many times, but in the long run, you will win.

The Secret - Scientifically Pricing Options

The secret then to successful options trading is to buy options that are underpriced and sell options that are overpriced. Better yet, in the options market you have the rare ability to measure the true worth of your investment (options) easily through scientific means.

But if the real worth of any option can be quickly and clearly measured, then why are all options not priced at their true worth in the options market? Like any investment market, the options market is filled with investors and speculators who think they can predict the unpredictable. They believe they can predict short-term moves in the stock market (but most of them can't). Therefore, they purchase options based only on the merits of the underlying stock, without bothering to look at the price of the option itself. In addition, the emotion and uncertainty present in the stock market is magnified in the options market. Options, being highly leveraged instruments, exaggerate the emotional optimism or pessimism of the market, causing option prices to vary widely from their true worth.

The Key to the Treasure Chest

The key to determining the true worth of a put or call revolves around identifying the volatility of the underlying stock or futures. Most common stocks and futures usually have a consistent volatility pattern over the years. By measuring the average price volatility for the past three to five years, an estimate of future volatility can be obtained. If you can combine your longer-term volatility estimate with a short-term measure of volatility, you can better pinpoint the future volatility of the underlying stock or futures.

The more time spent in estimating the price volatility of the underlying stock or futures, the more accurate you will be in determining the true worth of a put or call.

The Art of Pricing Options

If pricing options is the key to success in the options game, how can you as an investor scientifically measure whether an option is over- or underpriced? The professionals and market makers on the options exchanges use computers to determine whether options are over- or underpriced, and they usually use a pricing formula called the Black & Scholes model, or a variation of that pricing formula. The Black & Scholes pricing formula estimates what the market price of an option should be, and it does this by determining the cost of creating a perfect hedge in the market, using options and stocks or futures.

The Black & Scholes model provides a good estimate of the true worth of an option, but because it weights interest rates, it, in some cases, distorts that true worth when interest rates are high. We use the Black & Scholes model for determining prices at times, but we also use our own pricing system, which takes a probability distribution, and uses a form of computer simulation to measure true worth.

But from a practical point of view, don't be alarmed by the mathematics of measuring the proper price of an option. Many of the established methods for scientifically pricing options can be followed, and any method is better than none. The important consideration is that you make some attempt to determine whether an option is over- or underpriced.

Here are some suggested ways to handle the pricing of options. First, approach the pricing of options the way you approach the pricing of a used car. When you buy a used car, you should have a blue book in hand to measure what the proper price should be. In the options market, when you attempt to find some puts or calls for purchase, you of course select stocks that you feel are the best prospects for option buying.

Your next step is to identify what are the best options available for option buying. Here, to ensure that you are going to be buying the best priced options, you need a blue book, and that blue book could be The Option Player's Advanced Guidebook (available from Institute for Options Research, Inc., P.O. Box 6586, Lake Tahoe, Nevada 89449 for a price of $35.00 plus $4.00 for shipping and handling). This book has 160 pages of pricing tables that can be used to make an estimate of what the price of an option should be. After looking up your chosen option in the tables, you would then compare it to its actual price in the market today.

This is a broad brush, simple and fast method of pricing options. Better yet, you can compete with the professionals by using your own home computer to measure whether an option's price is undervalued or not. OPTION MASTER® can be used on a almost all computers, and does a sophisticated job of pricing options. (Here you can become far more exact in measuring the real worth of an option price.)

There is another alternative, and that is to use option advisory services where much of the work in identifying underpriced options has been done for you, such as the Trester Complete Option Report, where many man-hours are spent identifying the best underpriced options in the market. (Be wary of advisory services that recommend options, but ignore option prices.)

Whether you use an advisory service, your computer, or a book to price those options, some attempt must be made to make sure that the options you are purchasing are, at the very least, fairly priced; better yet, that the options are underpriced if you are buying options, and overpriced if you are writing options.

Just remember, the difference between a professional and an amateur in the options market is determined by the amount of time spent pricing options. Regardless of what you think the underlying stock or commodity will do in the future, don't buy an option if it is overpriced, or write an option if it is underpriced. When you buy overpriced options, you are no different from the gambler who throws his dollars into the slot machines in Las Vegas. In the end, you will lose.

To improve your skills in pricing options, do some homework by studying The Option Player's Advanced Guidebook, or one of the other books available on pricing options, such as Option Pricing & Strategies in Investing, and Strategies for Put & Call Option Trading.


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