Importance of knowing basics of options pricing for interviews/IB work

Chapter 2 of "Heard on the Street" is a bunch of options pricing questions - is it important to know how to solve these problems for summer analyst position interviews? If so, I'm going to have to buy an options pricing textbook (does WSO's technical guide go through these?).

 
Best Response

WSO's guide gives a brief overview of Black-Scholes. But honestly I can't imagine the interviewers for IB would probe you on the topic. I've only ever been asked about the difference between basic shares outstanding and fully diluted shares outstanding a couple of times (and that's not really related to options pricing, just what happens if options are in the money). It probably makes a lot more sense to sure up your answers to "why do you want to do investment banking" and other fit questions than to worry about options pricing. The former is going to be make-or-break; you probably won't get a single question on options pricing.

 
jimbo_slice:
WSO's guide gives a brief overview of Black-Scholes. But honestly I can't imagine the interviewers for IB would probe you on the topic. I've only ever been asked about the difference between basic shares outstanding and fully diluted shares outstanding a couple of times (and that's not really related to options pricing, just what happens if options are in the money). It probably makes a lot more sense to sure up your answers to "why do you want to do investment banking" and other fit questions than to worry about options pricing. The former is going to be make-or-break; you probably won't get a single question on options pricing.

Thanks a lot for the advice! I guess Heard on the Street's options pricing chapter is for potential quants and traders...

 

No problem. Just focus on "Why banking?", "Why this firm?", "How do you value a company?", "Walk me through a DCF", basic accounting, general fit questions about being a team player, hardworker, etc., and current events, and that's going to be about 80% or more of the game. By all means read as much as possible but those questions are make or break so nail those and you are in good shape.

And yeah it definitely sounds like that book is geared more towards the trading side. I thought the WSO and Vault guides were really solid info. WSO's book is pretty cheap and, at least for me, the Vault guide was free thru my school's career center so you might be able to pick that up through yours too.

 

Show some modesty, make fun of yourself a bit, act the hard worker and nice guy. The fact that you're so worried about the technical BS probably means you don't have the personality for banking. Banking is ultimately just a sales job. Sorry to be the bearer of bad news.

 
pay no fees:
Show some modesty, make fun of yourself a bit, act the hard worker and nice guy. The fact that you're so worried about the technical BS probably means you don't have the personality for banking. Banking is ultimately just a sales job. Sorry to be the bearer of bad news.

I'm with you - I'm way more interested in consulting but want to do an IBD internship in case I don't get a good consulting internship (it's much, much harder to get a summer internship with MBB than it is to get a FT offer).

But that's kind of idiotic for you to say I don't have the personality for banking because I'm asking about technical questions. I have a completely non-technical background, so why wouldn't I worry about the technical questions that I have currently no idea how to answer? You're saying no one who's ever gotten an IBD job thought about technical questions when preparing for the interview? Have you even had any real IBD SA interviews?

 

Depends on what role its for/your interviewer.

For trading I have had plenty of interviews for summer analyst positions that were extremely technical, but that is partly because that was my edge in recruiting and I led the interview down that path. A lot of how technical your interview is will depend on you and how you answer questions.

 

Ignore pay no fees, he's got no idea what the hell he's talking about. If you go to interviews without technical knowledge, you'll most probably get owned. That said, anything beyond Black-Scholes is probs a bit much for SA in terms of options knowledge, and even that may be overkill. More relevant would probably be the treasury stock method (as mentioned above). Still, maybe better to be safe, after all its just a formula.

afroman23

 

Not sure I completely understand what you're asking ...

If you follow an intrinsic value-model for pricing stocks, then any change to the expected values of the future stock price (which, if you remember, are discounted back to today) would alter the value of the stock in question today. (i.e. the price of apple stock is based off of what people think apple will be worth in the future ... if these 'future' values change, then the value today changes accordingly).

It sounds like your test is asking you what happens to the option price when the growth rate of your stock increases. Recall that the Gordon Growth Model views the value of equities as a growing perpetuity. With that in mind, you can increase the growth rate - this increases the stocks value ... and the rest follows quite simply.

As such, you're not holding the stock price constant. And what you're talking about is generally referred to as the 'delta' of an option - the derivative of the option price with respect to the underlying asset price.

You can derive the B.S. formula with respect to the Forward Value. This is done most simply by changing the numeraire that you use. However, in order to avoid arbitrage, the value of a forward is known via the current value of the stock and the interest rates (easily computed if you assume they're constant).

Again, I'm not exactly sure what you meant.

 

Let me clarify--say there are two stocks, A & B, that have the same stock price, same overall volatility, etc. The only difference is that A has an higher expected growth rate (say, due to a higher beta). Would ATM calls for A and B be priced differently?

 

Definitely yes.

The likelihood that A's price will be higher at maturity than B's is increased(assuming strike prices are the same) and is therefore more likely to be in the money, which translates into a higher option price today.

"The power of accurate observation is commonly called cynicism by those who have not got it." - George Bernard Shaw
 

If one stock has a higher beta than the other, both the puts and calls will have a higher Implied Volatility (different from the volatility of the stocks past moves), thus be more expensive.

If there's a lot of hype about a particular direction (a lot more volume in calls vs puts) then perhaps the calls will be more expensive and the puts will be cheaper.

I'd have someone confirm my answer as I'm in no finance-related major, but trade options frequently.

 

when you're short options you're short convexity, which means that when positions move against you, you begin to lose at an increasing rate(because of being short gamma). In that same token, when you gain on the position, you are making gains at a decreasing rate (same logic applies).

Basically, if you're not delta hedged, and your delta begins to move against you, it will begin to move against you faster and faster. And when it moves in your favor, it will do so slower and slower.

 

Yup. That's the impact of convexity. One thing you may want to consider is doing bull/bear spreads instead. They're a lot more gamma neutral, though still experience positive/negative convexity around the strikes.

One thing to be careful about when delta-hedging options positions is the Charm. In theory, if you have a delta-hedged call and the stock price is moving up quickly towards the strike, you're making money. In reality, you're losing money short the stock and until you pass the strike, you've got an option with a value of zero at expiry.

 

Building on the convexity argument, let's say you start with spot = high-strike of the call backspread. As spot falls and you approach your short-strike, you are moving into the (likely) most short gamma portion of your structure. Conversely, as spot goes higher, you move away from the +ve gamma of the high-strike.

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
 

Short gamma isn't always a bad move- you get paid for that convexity. It is just a move that you have comprehensively understand before you get into it. You go short gamma because vol is really expensive for no good reason, and then generally on behalf of an investment bank or trading firm rather than a personal account.

I will go long gamma and sometimes do bull/bear spreads in a personal account but stay away from the more complicated strategies.

 

What would be your best recommendation for getting a better grasp on convexity in a context that is less complex as Hull, if possible? I do have a decent grasp on the greeks in general, but where I need work is with application of principles. I can sit here and regurgitate what I've learned and read, but I need to better apply it.

Is this possible, or is it solely from experience? Keep paper trading strategies and theories, perhaps?

quote=IlliniProgrammer]Short gamma isn't always a bad move- you get paid for that convexity. It is just a move that you have comprehensively understand before you get into it. You go short gamma because vol is really expensive for no good reason, and then generally on behalf of an investment bank or trading firm rather than a personal account.

I will go long gamma and sometimes do bull/bear spreads in a personal account but stay away from the more complicated strategies.[/quote]

 

Just have to get experience at it and a strong working knowledge of it. You also need a strong analytics toolkit- one that can give you current strike vols, historical vol, etc. If you work with options or vol products as a quant on a full-time basis, you will get comfortable with all of this stuff- moreso if you are a trader.

I will spot some anomaly in the vol market and see if there's anything I can do with my limited PA choices on vol strategies- (long call, long put, bear/bull spread) to fix it. Going just long vol, I lose everything 70% of the time, but quadruple my money the other 30%.

It is a tough market if your counterparty is professional market-makers, but they still make enough mistakes that a smart person can still win in this game.

 

if you have a rough idea of the greeks for calls and puts, the best thing to do is to take a pen and piece of paper, put on some music and try to draw out the greeks of straddles, call spreads, risk reversals, butterfiels, calendar spreads. Once you have that and you feel comfortable with it, move on to the second order greeks, most importantly change of the greeks with respect to vol/time.

Trust me, if you devote a couple solid hours to this you will have a great grasp of the greeks.

 

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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

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