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=NASDAQ:GOOG
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?
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.
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?
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.
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.
I think you forgot kurtosis.
^don't forget about those black swan events as well.
That's not how a risk-neutral measure works, bro.
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.
//www.wallstreetoasis.com/blog/four-myths-that-b-school-shattered-for-me?…
//www.wallstreetoasis.com/blog/four-myths-that-b-school-shattered-for-me?…]
I agree with all your thinking, you broke it down very well.
Here is what I meant; http://www.schaeffersresearch.com/schaeffersu/beginning_options_strateg…
//www.wallstreetoasis.com/blog/four-myths-that-b-school-shattered-for-me?…]
I'm going to respond in the other thread, as I sort of disagree with you.
**Edit, I misread part of your statement, damn I wrote up paragraph discussing realised vol for nothing apologies!
By the way, if you want a good rule of thumb for determining if an option will finish in the money, all you need to do is look at the absolute value of the delta of the option. At the money call options have a delta of about 0.50, meaning there is about a 50% chance it will finish in the money. In the money call options will have higher deltas (maximum of 1.00) and out of the money options will have lower deltas. (minimum of 0.00). For puts, just ignore the negative sign and it's the same signal.
Back to the original topic, options prices themselves are reliant on our best guess of what volatility, wings and skew is worth. None of this is known. And when it comes down to it, I'm probably as likely to correctly value what the realised volatiltiy of an o/n option is as a spot trader would be to guess the spot rate in 24 hours. Obviously there are a lot more complexities in terms of trading options (how to make money), but the one thing you should always remember that their value, while based on a model, is only as good as the inputs that go into it.
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