Ok... so I'm trying to get more technically sound in my personal investing/trading. I've been looking into options and am trying to do my own analysis to understand price movement and pricing.
So a few things... I'm looking at financial companies, so keep that in mind. How far back should I look historically?
Also, where can I get historic options pricing? My brokerage account doesnt give historic options pricing, neither does yahoo finance. Would prefer not to have to be sitting at the bloomberg terminal doing obviously personal research.
First off, options investing is EXTREMELY risky if you do not understand what you are doing. So, my first instinct, based on the fact you are asking questions about this, would be to advise you to not do this at all and stick to investing long in the equity or debt of companies you believe in. Obviously, this is not what you want to hear so you will therefore ignore me. So if you insist on pressing on, I'd say that for derivatives, looking back isn't very useful. The price of an option at a given strike is based almost exclusively on two things - 1) the time to expiration and 2) the volatility of the underlying security. Only for volatility will historical data give you any insight whatsoever, and at that, we're still talking about data for the stock, not the option. Embedded into the option is a market expectation of what the volatility will be so all you're really doing is betting on whether the volatility will be less or more than that. So the decision at hand really has very little to do with historical data. Additional, when we're talking about a stock, these are securities that can conceivably be held forever. The equity will behave based on the expectation of the equity holders to get any money out the company. Options however, last for about 3 months. They don't really "behave" like anything, rather they just respond mathematical rules and no arbitrage conditions based on certain market assumptions. E-Trade runs ads telling us that we need to "look at charts" and "do some analytics" but really, most investing has very little to do with historical data and you're much better off trying to figure out what business models are most likely to work and make money going forward. Obviously this is very difficult to do.
How would you calculate delta, theta, vega etc... without looking at historic data?
Why would you need to? Use an options calculator.
Study the greeks, understand the different vol surfaces of various options, understand theta and vega, get a grasp of the volatility smile, understand put-call parity, think about a trade idea and what the best way is to express that with options.
If you are an out-of-this-world stock picker, you can get by just using options as a levered long/short but for the rest of us, you really need to understand the true dynamics of options trading.
Update: STAY FAR AWAY FROM OPTIONS INVESTING.
An option replicates a levered position in a stock, so the "delta" you speak of is simply the proportion of stock in a portfolio of stocks and bonds that replicates the payoff of the derivative. This relationship has nothing to do with historical data.
Imagine a graph that plots the price of an option against the price of the stock. How does this graph come about? It is generated by the BlackScholes formula that takes current stock price, strike price, time to expiration, interest rate, and a market assumption of volatilty. Once again, the inputs in this relationship have nothing to do with historical data. Going back to the greeks, the "delta" of an option is the first derivative (slope of the line) of this graph plotting the option price with respect to the stock price The "gamma" is simply the 2nd derivative of this same graph. "Theta" and "vega", like the Greeks described above, are mathematical relationships that behave according to Black-Scholes, again having nothing to do with historical data. Like I said, the only thing that history could possibly have any bearing on is the volatility. Even then, looking back to determine the future is financial astrology and, for the good of capital everywhere, cannot be debunked hard enough or often enough.
Words of wisdom.
Just stay away from investing in options. There are plenty of other instruments out there to invest in (see my other posts).
Even Mr. Scholes (the one from the Black-Scholes Model) got burned trading on the wrong side of options when he was with Long Term Capital Management (LTCM). Read the book "When Genius Failed" when you get a chance.
Thanks for the added color.
I should have been more clear perhaps. I just want to fully understand greeks and how options behave.
As for ideating... I am a very good stock picker, that spurred my interest in options. I typically get 1 or 2 good ideas, go in heavy and ride it out to outsized returns. Lately, I've been experimenting with 12-24 mos. out of the money options, with very modest amounts. So I got 3 good investments (I think of them more as trades since I think I'm playing off market sentiment/trend moreso than investing in a sector/business model), and bought heavy into the stock and grabbed a few LT out-of the-money options. I'm just trying to understand the behavior a bit more. As one of you mentioned, its mathematical relationships... thats what I'm trying to get my arms around.
How long have you been investing?
Read Derivative Markets by Robert McDonald.
Another funny story about the Black Scholes model is when it was derived, the brainiacs who discovered it went hunting for mispriced options before they rolled it out - obviously there were a fair number of options market makers out there already - and guess what... They couldn't find any.
A model (e.g. Black-Scholes) can calculate theoretical delta and the rest of the greeks with a few inputs, or you can always estimate using the at-the-money option = .5 delta rule (roughly) and go from there. Tinker around with this model to get better acquainted with options pricing:
http://www.optiontradingtips.com/pricing/free-spreadsheet.html
I disagree that options trading is patently risky. Buying options is akin to taking gambles on stock direction (in directional trading only) where the premium paid is much lower than having to buy the underlying to make the same bet. I can lose my entire premium but no more (limited loss). However, option writing opens up the trader to greater loss potential and this is why such strategies are typically limited to clients with large amounts of cash or many years of experience with the major discount brokers.
I don't recommend becoming even a directional trader without learning more about pricing and how the greeks work though. By the way, I do agree with jhoratio that time to maturity and volatility are the main drivers of vanilla options pricing. I'd start your search there.
The Bloomberg terminal has always been my destination of choice for historic prices on options. Never used it for analysis but only to double-check client fills.
I think there are a whole bunch of misinformation on this thread. At the end of the day purchasing or writing an option that is not deep in the money is a bet on the future volatility of the underlying product. Black-Scholes is almost certainly NOT wrong as a previous user mentioned. The fact that two of the three academics responsible for proposing the Black-Scholes model was involved in LTCM has less to do with the formula itself than the fact that they were (to simplify it) on the wrong side of the volatility trade. They were short volatility when volatility spiked.Nearly every market participant whether it be a casual options trader to the big market makers and big banks use Black-Scholes as the basis for their pricing model.
OP> If you are serious about options (and you should be because if you are wanting to be in S&T, nearly every non-delta one product includes optionality) read Natenberg's book. If you want it, I have the PDF and will send it to you.
Options trading also need not be riskier than playing the underlying asset. Options are at its core insurance. Its a coupon which allows you to buy or sell a security at a set price, at a set time in the future. One of the previous posters is right is stating that writing options is riskier because you are short vol. Imagine you are a homeowner in Florida purchasing insurance from me, the insurance agency. If a hurricane does not hit, your only loss as the homeowner is the cost of paying me the premium which is what I earn. On the other hand, if a hurricane does hit, your insurance pays out multiple of the premium which I need to cover. The key for me as the insurance agency is to figure out the price which estimates the probability of the hurricane hitting (and my payout if it does hit) so that I can make money over the long run. An options price is (roughly) the market's judgment of what the probability of the particular security being above/under that stock is.
^^^What on earth are you talking about?
No one said Black-Scholes was wrong and no one suggested that it wasn't universally utilized. In addition, the reason why writing options is dangerous is not because you are "short vol", but because you could conceivably expose yourself to unlimited losses in some cases.
Thanks also for the completely useless, and erroneous, example of options as insurance. The glaring error is that only a put option is like insurance. The other is that option pricing is done (as you yourself said) via Black-Scholes, not by some ridiculous estimation of whether or not some metaphorical hurricane is going to make landfall.
And once again, options ARE riskier than the underlying. Risk is volatility. Volatility is risk. Since an option is simply a levered position in the stock, and we all know that leverage magnifies the gains and losses associated with a position (i.e. the volatility of the position), it is by definition a riskier position than the stock.
When you sell an option you are shot vol and that is certainly one of the reasons writing options can be quite risky. The first and third paragraphs of this are total mumbo jumbo and the second paragraph is just an immature attempt at an insult. thanks for wasting 45 seconds of my life.
Options have their place in a trader's toolbox and it is an unwarranted generalization to say that options are always "riskier" or "less risky" then trading spot positions. When vol is cheap or when you have a view that vol is likely to pick up then it sometimes makes sense to buy options instead of holding a spot position and conversly at certain times when vol is rich it makes sense to sell options. I think the reason why options get a bad rap is that unsophisticated investors (even highly paid profesionals) are often lured into selling out of the money options because they seem to be "free money" when in fact it is obvious that they are not. The fact that this strategy will usually work reinforces that idea and causes people to keep selling options, or do short vol trades that mimic the return profile of option shorts, to the point where they end up blowing up when vol picks up. In my opinion, the whole LTCM thing was just a good salesman (Merriweather) hiring a bunch of PHDs so that he could raise money and do a bunch of trades that were just the equivalent of selling out of the money options. And Merriweather ended up very rich by the time it finally all blew up.
I don't know about that. LTCM could have been a successful fund over the long-term, except for a few key (human) missteps. For example, their monthly statements on VaR would be laughed at by a junior in college while their CVaR estimates were a complete joke. The stat arb stuff they were doing is definitely profitable over the long run and while it may have had a heavy low vol bias, it certainly was not equivalent to selling out of the money options. As an example, some of their Euro-bond convergence trades were bread and butter for GS Global Alpha for a number of years. Their Japan convert-arb strategy was essentially mimicked by DE Shaw in '01 and '02 and a number of their tactical BoE yield curve plays were solid, solid trades.
Aside from the normal distribution BS and lack of "animal spirits" (even though Akerlof is a yahoo, it's still a great phrase), LTCM was way ahead of its time on a number of strategies. Would have thought you would give them more credit, especially given your handle.
Well being short vol and gamma I'd say is fairly dangerous if you don't know what you're doing.
Options are exactly like insurance, even calls. Consider this:
You're a Gulf of Mexico oil producer with offshore rigs that may sustain damage from a "metaphorical" hurricane coming into the area. The producer stands to lose potential revenue if the hurricane causes extensive damage to Gulf rigs and oil prices rise. So to hedge this risk, or to insure against the potential loss of revenue, the producer can buy call options to allow for participation in any upside if their rigs are down and prices rise.
It's also funny to think that you can create a synthetic loan at the risk-free rate using a combination of buying and writing those risky options.
jhoratio> Firstly, I did not make a personal attack but since you started it here is my response:
You do realize I noted that it was simplification right? In addition, are you actually arguing the LTCM trade wasn't a short vol trade? I can bring in gamma curvature here but at the end of the day they were on the wrong side of the short vol trade. The fact that they kept their downside uncapped doesn't nullify that fact.
You don't understand analogies do you? It was presented to show what an option was and how risk is asymmetric depending on which side of the options trade an individual is one. And no, good market makers account for fatter tails and price out-of-money options greater than its textbook Black-Scholes price. In addition, there the insurance analogy isn't mine and has been used in a number of options books. Another common analogy is the "coupon to buy a VCR in the future". I guess you will find faults with those too.
And thirdly, an option is NOT a leveraged position of the underlying. Using your risk=vol argument, I can right now construct an options position where the payoff will be less volatile and capped both on the up/downside than a pure underlying position.
If you are inclined to start an internet pissing match (and no one wins in those) do your research first.
I just find it funny that people talk about options in terms of trading vols, and then end up not delta hedging and still think they're trading just vols.
Why is the title "The Greeks"?
nevermind, found it myself
http://en.wikipedia.org/wiki/Greeks_(finance)
Read "Options traders guide to volatility, probability and timing" by John Wiley
I think a good way to see it is classifying trading strategies in two classes: convergent (relative, FV based plays etc) and divergent (trend following etc). They tend to have similar reward:risk payoff distros and tend to behave in tandem particularly during liquidity events.
I found this article to be a pretty decent description between the two (sorry for the ridiculously long address):
http://www.google.com/url?sa=t&source=web&ct=res&cd=7&url=http%3A%2F%2F…+trading&usg=AFQjCNF3XIxhd4YkCnWm6buJ5xlLxMg1uw
Dolor perferendis ut veritatis aliquid et odio vitae. Consequatur laboriosam vitae nisi vel adipisci vitae quaerat. Provident cupiditate occaecati quia at consequuntur recusandae.
Aliquid non earum nobis consequatur deserunt ea qui. Molestias error ex et impedit minus voluptatem et saepe. Libero dolorum voluptatem recusandae dolores aut commodi. Itaque odio debitis nostrum voluptatem veritatis amet et eum.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...
Quas quod perspiciatis molestiae adipisci quam autem voluptas. Culpa deleniti ut nisi sit dignissimos nihil ut. Beatae neque qui ab eveniet voluptatem.
Vel debitis omnis totam qui rem consectetur. Quae maiores amet error. Est voluptas cupiditate exercitationem illum perspiciatis officia. Autem itaque commodi ut autem dicta.
Aut molestias quis voluptatibus delectus aut. Ut officiis qui voluptatem quia enim nihil. Quos nihil necessitatibus eos nemo. Expedita omnis tenetur aut eos quo. Laboriosam nisi quaerat quia ullam quis beatae eos. Voluptates molestiae ratione omnis eos.
Eos fuga ducimus aut dolorem qui voluptas. Mollitia tempore voluptas quia nihil nihil molestias sed. Aliquid enim id adipisci ullam reiciendis minima. Ratione eius perferendis molestias atque recusandae. Corrupti eos architecto sit dolores blanditiis nostrum nostrum.