Tales From The Trading Floor II

Option Pricing

Too
many option novices fail to understand why option prices may race
higher and lower – sometimes with no apparent reason.  When these
investors pay the offering price one day and sell at the bid price the
next, they understand they have lost money, but they feel the need to
complain in those online forums.  They just 'know' the market makers
cheated them, when in reality they made trades with the odds of success
stacked against them.  Being unable to understand, and often
unwilling to learn, they lash out at market makers.

The best
example of this occurs prior to an earnings announcement.  I've written
about this topic previously, but here's the situation:  When stocks such
as GOOG, AAPL, RIMM are about to announce their earnings, many traders
are looking to earn substantial profits – if the stock undergoes a big
price change.  Because those changes do occur (but not every time),
those traders are buying calls and/or puts in an effort to profit from
such a move.  When options are bought in increasing numbers, the people
who sell the options – and that's mostly market makers – steadily
increase prices.  Those prices are not raised to 'cheat' the
customers who buy.  Instead, it's an attempt to maintain a fair and
orderly market – and hopefully to attract sellers to help meet the demand.  But when that demand far exceeds supply, prices rise.  

Then
there's the problem of which option to buy.  Looking to take a chance
in an effort to make a 'killing' too many beginners purchase far out of
the money options because they can buy a bunch of these options trading
at relatively low prices.  In this sentence, the word 'low' means 'not
too many dollars' rather than 'at a low implied volatility.'

If
you have never noticed this phenomenon, you can do so by monitoring the
implied volatility (a measure of how 'high' or 'low' option prices are
at any given time) during the day when news is expected after the close
of trading or before the market opens on the following business day. 
It's an educational experience.

At
he close of the day's trading, everyone who wants to own these puts and
calls has bought them.  The news is released, and the stock opens for trading
the following day.

If
the stock jumps 10 points higher, the put owners
know they lost money, but the call owners eagerly wait for the
options to begin trading – to see just how much money they made. 
Many people make the mistake of entering market orders to sell their
call options, in an attempt to capture a nice profit without being greedy.

The
options begin trading, the calls owners sell their options, and the
anguish and accusations begin.  First, the call owner bought
options when the demand was high, so they paid a higher than normal
price.  Next, they sold when everyone else was selling, so they
received a lower than normal price.  But the worst part, is that they
have incurred a loss, despite the 10-point hike in the stock price.  "How," they ask, "can the stock move higher by so much, and my call options decline in price?  I must have been cheated."

No,
not cheated.  They simply bought the wrong options (too far out of the
money) and paid a very bad price due to the high implied volatility.  Now
that implied volatility has returned to normal (or even lower), it's
very reasonable for out of the money options to decline in value. 
[Play with an option calculator to see how this works.]

It's important to understand how options are priced before you begin trading them.  And if you take a loss, don't blame the market makers.

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2 Responses to Tales From The Trading Floor II

  1. DP 11/25/2008 at 5:39 PM #

    Thanks for writing these articles Mark, it’s great to get some insight into the trading floor.

  2. Mark Wolfinger 11/25/2008 at 8:00 PM #

    I’m sorry I have nothing more recent to relate. Electronic trading changes much of the game.
    Mark