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Betting Odds on the Market – Option Trading
 

BCbanker's picture
IB
(Gorilla, 633
 
Points)
 on 8/18/12 at 6:30pm
horses

Did you know that you can easily find out the odds of a stock moving in a certain direction using option prices? Please, no option traders jumping down my throat on this one. Google has a 6% chance of increasing 10% in the next month. Check this out:

http://www.google.com/finance/option_chain?q=NASDA...

Select an expiration you like. I chose September 22, or a little longer than a month out. If you graph the differences in option prices for out of the money calls and pair it with the differences in out of the money puts, you will quickly see the normal distribution, consistent with the efficient markets hypothesis that prices have an equal chance of increasing or decreasing.

Take any two prices to find the percentage chance that the stock will go to that strike price within the expiration period. Today’s close price of Google was $660. A 10% increase to a strike of 720 has a 1.55-1.25 = $0.30 / $5.00 = 6% chance before September 22. Said in a different way, that’s a 16.7x payout. Anyone want to take those odds?

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Comments

mrktmaker's picture

If you are playing poker,

(Monkey, 34
 
Points)
 on 8/14/12 at 6:20am

If you are playing poker, would you want to win (by your calculation) a $1.55 pot 94% of the time, or just win the gains above 721.55 6% of the time? Maybe you have information I don't have

Edmundo Braverman's picture

mrktmaker: If you are playing

ST
(Human, 14,330
 
Points)
 on 8/14/12 at 7:28am
mrktmaker:

If you are playing poker, would you want to win (by your calculation) a $1.55 pot 94% of the time, or just win the gains above 721.55 6% of the time? Maybe you have information I don't have

This is a great argument for writing covered calls, but I think the OP was making a point about the predictive value of option pricing.

slotmouth's picture

There is absolutely no

O
(Monkey, 38
 
Points)
 on 8/14/12 at 8:14am

There is absolutely no predictive value of the black sholes option pricing model. The assumptions are all wrong. It assumes that stock prices follow a geometric brownian motion. Stock prices do not move randomly otherwise GRPN wouldn't be down over 20% in the premarket today. Stocks have fat tails and move according to their financials, the news, expectations for the company, and the demand for the stock. Remember that options are priced according to models developed by the founders of LTCM, look how well that worked out for them.

WalMartShopper's picture

^don't forget about those

 
Points)
 on 8/14/12 at 9:16am

^don't forget about those black swan events as well.

If the glove don't fit, you must acquit!

BCbanker's picture

slotmouth: There is

IB
(Gorilla, 633
 
Points)
 on 8/14/12 at 9:36am
slotmouth:

There is absolutely no predictive value of the black sholes option pricing model. The assumptions are all wrong. It assumes that stock prices follow a geometric brownian motion. Stock prices do not move randomly otherwise GRPN wouldn't be down over 20% in the premarket today. Stocks have fat tails and move according to their financials, the news, expectations for the company, and the demand for the stock. Remember that options are priced according to models developed by the founders of LTCM, look how well that worked out for them.

slotmouth, I don't think these are fair points. You can certainly have a 20% drop in a normal distribution. The idea is that at time = 0 you have no idea which direction and how far a stock will move. Options tell you that. I used the term "normal" lightly. If you graph the distribution it actually does have fat tails.

Options are entirley investable. If you believed the distribution is not represented by the pricing model, then there is an incredible opportunity to profit.

What is your counter argument? How do you think stocks move?

SirTradesaLot's picture

slotmouth: There is

O
 
Points)
 on 8/14/12 at 10:05am
slotmouth:

There is absolutely no predictive value of the black sholes option pricing model. The assumptions are all wrong. It assumes that stock prices follow a geometric brownian motion. Stock prices do not move randomly otherwise GRPN wouldn't be down over 20% in the premarket today. Stocks have fat tails and move according to their financials, the news, expectations for the company, and the demand for the stock. Remember that options are priced according to models developed by the founders of LTCM, look how well that worked out for them.

Look up skew.

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

BCbanker's picture

SirTradesaLot: slotmouth: T

IB
(Gorilla, 633
 
Points)
 on 8/14/12 at 10:34am
SirTradesaLot:
slotmouth:

There is absolutely no predictive value of the black sholes option pricing model. The assumptions are all wrong. It assumes that stock prices follow a geometric brownian motion. Stock prices do not move randomly otherwise GRPN wouldn't be down over 20% in the premarket today. Stocks have fat tails and move according to their financials, the news, expectations for the company, and the demand for the stock. Remember that options are priced according to models developed by the founders of LTCM, look how well that worked out for them.

Look up skew.

Skewed left or right? If you don't know then efficient distribution is normal (with some fat tails). Options do have predictive power.

SirTradesaLot's picture

BCbanker: SirTradesaLot:

O
 
Points)
 on 8/14/12 at 10:53am
BCbanker:
SirTradesaLot:
slotmouth:

There is absolutely no predictive value of the black sholes option pricing model. The assumptions are all wrong. It assumes that stock prices follow a geometric brownian motion. Stock prices do not move randomly otherwise GRPN wouldn't be down over 20% in the premarket today. Stocks have fat tails and move according to their financials, the news, expectations for the company, and the demand for the stock. Remember that options are priced according to models developed by the founders of LTCM, look how well that worked out for them.

Look up skew.

Skewed left or right? If you don't know then efficient distribution is normal (with some fat tails). Options do have predictive power.

I agree with you. Skew just shows you how much higher implied vols are for various strikes, which is how fat-tails are accounted for in the options market. Alternately, the vol smile is how some reference it. Options have predictive power for the distribution of potential returns, they don't generally have predictive power for the direction of the stock or the market.

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

slotmouth's picture

I do think that options are

O
(Monkey, 38
 
Points)
 on 8/14/12 at 11:43am

I do think that options are great investment products, and I take advantage of what I feel are mispricings all the time. I don't think that you can put stock prices into an accurate predictive model because there are too many inputs. The fat tail events cannot be predicted by any model. For GOOG the simple black-sholes model does not predict the outcome of lawsuits, new developments in google labs, security breaches, anti-trust legislation, QE3, etc.

I do know that those rare fat-tail events occur a lot more often than option price models predict. Just because something was volatile doesn't mean that it will continue to be volatile, and vice versa. I don't claim to have a predictive model for how stocks move, nor do I think they move randomly. They did not predict the massive drop in Knight capital and they won't predict whatever the next major crisis is, otherwise it won't be a crisis.

BCbanker's picture

slotmouth: I do think that

IB
(Gorilla, 633
 
Points)
 on 8/14/12 at 2:20pm
slotmouth:

I do think that options are great investment products, and I take advantage of what I feel are mispricings all the time. I don't think that you can put stock prices into an accurate predictive model because there are too many inputs. The fat tail events cannot be predicted by any model. For GOOG the simple black-sholes model does not predict the outcome of lawsuits, new developments in google labs, security breaches, anti-trust legislation, QE3, etc.

I do know that those rare fat-tail events occur a lot more often than option price models predict. Just because something was volatile doesn't mean that it will continue to be volatile, and vice versa. I don't claim to have a predictive model for how stocks move, nor do I think they move randomly. They did not predict the massive drop in Knight capital and they won't predict whatever the next major crisis is, otherwise it won't be a crisis.

The counter argument to the fat tail theory is that there is considerable room to profit by buying call spreads that are out of the money. You say that they are very under priced and a strategy that bets on fat tail events would profit. Something tells me you do not have all your money in OTM options.

slotmouth's picture

You are right, I have about

O
(Monkey, 38
 
Points)
 on 8/14/12 at 5:33pm

You are right, I have about 10% of my money in otm put options right now. I think there is generally a pricing imbalance in anything with negative carry because it is psychologically painful to front the cash over and over until hopefully you are right. This is not a common strategy of mine, but the contrarian in me has a hard time ignoring all time lows in the VIX.

This was on my mind because I was watching bloomberg the other day and I saw a guy talking about an options strategy for groupon before the earnings. He noted that his strategy would make money unless groupon fell more than 20%, but not to worry as this was extremely unlikely. Oops.

ladubs111's picture

slotmouth: You are right, I

IA
 
Points)
 on 8/15/12 at 12:23am
slotmouth:

You are right, I have about 10% of my money in otm put options right now. I think there is generally a pricing imbalance in anything with negative carry because it is psychologically painful to front the cash over and over until hopefully you are right. This is not a common strategy of mine, but the contrarian in me has a hard time ignoring all time lows in the VIX.

This was on my mind because I was watching bloomberg the other day and I saw a guy talking about an options strategy for groupon before the earnings. He noted that his strategy would make money unless groupon fell more than 20%, but not to worry as this was extremely unlikely. Oops.

lol

acronym's picture

BCbanker: Take any two prices

CO
 
Points)
 on 8/18/12 at 7:28pm
BCbanker:

Take any two prices to find the percentage chance that the stock will go to that strike price within the expiration period. Today’s close price of Google was $660. A 10% increase to a strike of 720 has a 1.55-1.25 = $0.30 / $5.00 = 6% chance before September 22. Said in a different way, that’s a 16.7x payout. Anyone want to take those odds?

That's not how a risk-neutral measure works, bro.

"'In summary, people are morons and who cares. Make a shit ton of money. I've never seen a Ferrari paid for by what people think.' - ANT" -rufiolove

marcellus_wallace's picture

Are we saying Option guys

ST
(King Kong, 1,617
 
Points)
 on 8/18/12 at 9:19pm

Are we saying Option guys price things correctly? Because linkedin/netflix/etc have shown this year that the value guys owned the options dudes big time and more.

That said I would always use options open interest charts to see at what levels major resistance or major support is. This is a very common metric looked at in commodity trading.

blastoise's picture

BCbanker: SirTradesaLot:

O
 
Points)
 on 8/18/12 at 10:10pm
BCbanker:
SirTradesaLot:
slotmouth:

There is absolutely no predictive value of the black sholes option pricing model. The assumptions are all wrong. It assumes that stock prices follow a geometric brownian motion. Stock prices do not move randomly otherwise GRPN wouldn't be down over 20% in the premarket today. Stocks have fat tails and move according to their financials, the news, expectations for the company, and the demand for the stock. Remember that options are priced according to models developed by the founders of LTCM, look how well that worked out for them.

Look up skew.

Skewed left or right? If you don't know then efficient distribution is normal (with some fat tails). Options do have predictive power.

Disagree, options have quiet a bit of predictive power.

SirTradesaLot's picture

marcellus_wallace: Are we

O
 
Points)
 on 8/18/12 at 10:14pm

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

IlliniProgrammer's picture

slotmouth: There is

ST
(Almost Human, 9,197
 
Points)
 on 8/19/12 at 12:07am

Work hard, play hard.

marcellus_wallace's picture

SirTradesaLot: marcellus_wa

ST
(King Kong, 1,617
 
Points)
 on 8/19/12 at 12:46am
SirTradesaLot's picture

By the way, if you want a

O
 
Points)
 on 8/19/12 at 12:49am

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

SirTradesaLot's picture

marcellus_wallace: SirTrade

O
 
Points)
 on 8/19/12 at 12:54am

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

Revsly's picture

SirTradesaLot: marcellus_wa

ST
(King Kong, 1,706
 
Points)
 on 8/19/12 at 1:39pm

Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
-30 Rock

Revsly's picture

Back to the original topic,

ST
(King Kong, 1,706
 
Points)
 on 8/19/12 at 2:25pm

Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
-30 Rock

SirTradesaLot's picture

Revsly: Back to the original

O
 
Points)
 on 8/19/12 at 2:41pm

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

nontarget kid's picture

SirTradesaLot: slotmouth: T

ST
 
Points)
 on 8/19/12 at 7:40pm
SirTradesaLot's picture

nontarget

O
 
Points)
 on 8/19/12 at 7:57pm

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

nontarget kid's picture

SirTradesaLot: nontarget

ST
 
Points)
 on 8/19/12 at 8:00pm
SirTradesaLot's picture

nontarget

O
 
Points)
 on 8/19/12 at 8:06pm

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

Revsly's picture

nontarget

ST
(King Kong, 1,706
 
Points)
 on 8/20/12 at 1:02am

Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
-30 Rock

nontarget kid's picture

Revsly: nontarget

ST
 
Points)
 on 8/20/12 at 7:35pm
SirTradesaLot's picture

nontarget

O
 
Points)
 on 8/20/12 at 10:19pm

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

nontarget kid's picture

SirTradesaLot: I give you

ST
 
Points)
 on 8/20/12 at 10:54pm
SirTradesaLot's picture

nontarget kid: That

O
 
Points)
 on 8/20/12 at 11:16pm

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

Revsly's picture

Ok I'm going to stop using

ST
(King Kong, 1,706
 
Points)
 on 8/21/12 at 3:47pm

Jack: They’re all former investment bankers who were laid off from that economic crisis that Nancy Pelosi caused. They have zero real world skills, but God they work hard.
-30 Rock

nontarget kid's picture

Revsly: Ok I'm going to stop

ST
 
Points)
 on 8/21/12 at 7:13pm
moore.max's picture

The important theory lesson

ST
(Chimp, 10
 
Points)
 on 9/22/12 at 10:39pm

1.) What do you want?
2.) What realities are between you and what you want? What is true?
3.) What are you going to do about it?

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