How Are Options Priced?

A question asked by many novice options traders is: How is an options contract priced? Obviously knowing the value of what you are buying or selling is crucial to a successful trade. The basic model for options pricing today is the Black-Scholes Model developed in 1973 by Fisher Black, Myron Scholes and Robert Merton. The model is widely used today and is regarded as one of the best ways to determine the “fair” price of an options contract.

Generally the premium of an option has two main components: intrinsic value and time value.

 

When the underlying security’s price is higher than the strike price a call option is said to be “in-the-money.” If the underlying security’s price is less than the strike price, a put option is “in-the-money.” Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option’s exercise price, or strike price. Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor’s benefit, the greater the time value. There are several other factors that determine options pricing. Some factors are much more important than others and while some are readily known as fact (such as time until expiration), some are theoretical and therefore subject to interpretation (implied volatility).

 

The most basic and easily understood factor is change in the underlying security price which can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase and the value of a put will generally decrease in price. A decrease in the underlying security’s value will generally have the opposite effect. The strike price determines whether or not an option has any intrinsic value. An option’s premium (intrinsic value plus time value) generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of the money. Another, albeit traditionally less important factor, is the effect of an underlying security’s dividends and the current risk-free interest rate.This affect has a small but measurable effect on option premiums. This reflects the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning the shares outright. The interest rate and dividend affect can have a much more significant impact on options pricing in times of high interest rates  or when dividends, as expressed as a percentage of an stock’s price, is much higher than historical levels. A good example of this at the current moment is General Electric (GE). The stock price of G.E . has dropped significantly over the past few months and stands at about $13.00 in today’s trading. GE’s dividend, expressed as a percentage of the stock price, is a whopping 12%! Obviously that will have a greater impact on the pricing of the option as opposed to when GE was trading at $50.00!

Time until expiration, as discussed in our previous post, affects the time value component of an option’s premium. Generally, as expiration approaches, the levels of an option’s time value, for both, puts and calls, decreases. This effect is most noticeable with at-the-money options.

Implied Volatility is the most subjective and the most difficult factor to quantify, but it can have a significant impact on the value of an option’s premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option’s underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike.

Another factor that impacts the real value of an option is liquidity. If a contract is illiquid, generally the bid and ask spreads are wider. Lack of liquidity might make it difficult if not outright impossible to trade the contract. As you can see, options pricing is much more complex than plugging a few numbers into a formula. Pricing models will only account for the theoretical value of a contract and not the actual market value of an options contract.

 

 

Theta…The Most Important Greek!

 We wrote a piece some time last year regarding “Theta” and its impact on our strategies. I believe it is worth reviewing again as this important piece of the theoretical options pricing model addresses a very important component in Credit strategies such as Iron Condors and Bull Put/Bear Call spreads. 

Theta represents the measure for time decay of an option. Remember, an option price consists of intrinsic value and time premium. Theta measures the decay in time premium as every day passes until expiration. Therefore, we can say that the theta for a long call or put will be negative meaning that the options will lose time value everyday as time passes towards expiration. Conversely, the opposite can be said can be said for the short call and put, as time passes the positive theta will actually add to the value of a position. This is true because when you are long an option, you will lose money in that option every day all else being equal due to the time premium decaying. However, the time decay in a short option will increase your profits.

Theta does not adjust evenly as time goes on. As you can see in the chart below, Theta’s impact on a position’s value increases as time passes. The closer and closer the option is to expiration, the greater the time decay. Theta will accelerate at a higher rate especially when the option has less than 30 days to go. This also makes logical sense since the option has less time to get or stay in a profitable situation. Additionally, an options theta will be highest when the stock is at the money. Since the stock has basically no intrinsic value, the time value component is the majority of the premium and will fluctuate strongly as expiration approaches. The most pronounced time decay occurs in the last weeks and days prior to expiration

 Expiration and time decay are certainties making “net seller” or “credit” spreads our favorite options strategy. Remember, the value of an option is composed of time value and, if the option is in-the-money, it will also carry intrinsic value. By selling an option and holding the short position to expiration, you will only lose money if that option expires in-the-money.

 

Retail Woes Worse Than Expected

Retail sales figures dropped much more than most analysts expected for December, ending one of the worst retail holiday seasons on record. The Commerce Department reported Wednesday that retail sales dropped 2.7 percent last month, more than double the 1.2 percent decline that Wall Street expected and the worst figures since the 1969 season.

The Commerce Department in a separate report released figures on business inventories as well and said businesses cut their inventories by 0.7 percent in November, the largest decline in seven years.

Consumer spending accounts for about two-thirds of total economic activity making the retail weakness a major factor depressing overall economic activity. Many analysts believe the overall economy, as measured by the gross domestic product, plunged at an annual rate of 6 percent in the just-completed fourth quarter after dropping by 0.5 percent in the third quarter.

The results of the report has put pressure on stocks and at mid day the DOW has shed over 230 points to 8215 or a 2.69% decline and the broader S&P 500 is down 28.09 points or 3.22%. Also disturbing to market participants is the elevated volatility as measured by the VIX which has jumped over 15% in early afternoon trading.

Market Week Ahead 01/11/09

The week ahead will surely bring some more sour, but not unexpected economic headlines. The calender will be highlighted by the December retail sales figures due out on Wednesday and The Fed’s Beige book of economic indicators which is also due out on Wednesday afternoon. Both are expected to point to the continuing economic downturn. January Options expire this week and that should keep volatility elevated  maybe even adding a bit of volume to what has been very anemic trading.

 

The markets need to make a stand at these levels and further breakdown may lead to an earlier than expected test of some support levels. With that being said, I felt the trading activity last week did point to a somewhat more resilient market and the bears did not have as easy a time in asserting themselves. The market’s reaction to last week’s unemployment data was orderly and measured whereas just a few months ago, the same data would have sent the markets into a selling frenzy. No matter how one feels about the economic outlook and longer term market prospects, which by the way aren’t very good, the fact remains that this resilience undoubtedly points to a market that is indeed trying to form a base.

 

The markets are also going to keep an ear out for the squabbling that is developing in Washington over the economic stimulus package proposed by President Elect Obama. I suspect the honeymoon may be over before it even begins! Many Republicans and key Democrats have raised opposition to one aspect or another of the proposed measures. What a surprise…

 

Trading Volume Still Anemic

Trading volume at the NYSE continues to be extremely weak during a time where market analysts expected much broader participation. The lack of volume leads me to believe that both the recent bullish tone as well as the bearish tone of the last few sessions are not indicative of any longer term trends in the market. Low volume usually leads to higher volatility and indeed we have seen the VIX climb over 10 % in the last 3 trading sessions to around the mid forties.  We should expect some more volatile action in the broad indexes for the next several trading sessions into options expirations week before the bulls try to make another serious run at resistance levels of around 9600 on the DOW and around 1030 on the S&P 500. The fact that the markets have been making higher highs and higher lows is technically a bullish indicator and makes the lows set in November even stronger support levels.

The upcoming Jobs report on Friday is promising to be extremely weak. How the market reacts to the news will be very important and possibly the most telling sign for the 2009 trading year. We would pay attention to how the SPX trades over the next few days and the 850 level is key short term support. If we breach that level the bears may take us down for another test of the 820 level. The upcoming inauguration of President elect Obama may bring in some short term bullish bias to the market and hopefully a bit more overall trading volume.

Longer term I still believe we have to navigate through some tough economic conditions and I am bearish on the market prospects for the 2009. President elect Obama has really dampened expectations for a  2009 recovery and most economist do not anticipate positive GDP numbers until late 2009 at best and most probably not until 2010.

Fed. Begins Major Push to Lower Mortgage Rates

 

The Fed, as expected, began a program of buying mortgage backed securities with the aim of creating liquidity in the mortgage backed securities market. This action which was announced on Nov. 25th, hopes to help lower mortgage rates and make credit available to home buyers looking to get into the housing market. It is widely viewed by economists that this action will be successful in addressing  the question of availability of financing plaguing many qualified home buyers.  

 

This New York Fed program was launched after the Treasury changed course on using part of the TARP $700 billion bank bailout to buy some of these illiquid securities. Instead of addressing the illiquid assets as originally planned,  the Treasury has made direct investments in the equity of the larger national banks such as Bank of America, Citi and JP Morgan Chase. The verdict is still out on whether or not these funds, targeted at eventually loosening the frozen credit markets, have had the desired effect. Many analysts have raised a red flag regarding the lack of transparency and accountability by the banks use of these funds. 

 

The Federal Reserve Bank of New York’s purchases include fixed rate mortgage backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae  The Fed says it expects to release further details regarding the transactions after January 8th with weekly updates thereafter. The Fed has contracted several “large players” such as Pimco, the world’s largest purchaser of bonds, to help facilitate the purchase efforts which the Fed expects to wrap up  by June 30 of 2009. Many financial institutions hold these illiquid mortgage-backed securities including hedge funds and insurance companies. In another move aimed at reducing the impact of the credit crisis on the broader economy, the Fed will allocate $20 billion,  to back a consumer lending facility run by the New York Fed in order to provide liquidity for consumer loans such as student loans and credit cards. 

 

 

Market Week Ahead 01/04/08

 

The first full trading week of 09 will be highlighted by the new congress which will be sworn in on Tuesday. The market will focus on the speed at which the new congress can draft an economic stimulus package potentially worth close to a trillion dollars over several years. Democrats hope to have a bill ready for president elect Obama to sign as soon as he takes office on January 20th. Traders will be looking for hints as to who might benefit and who might lose from the massive stimulus plan.

December auto sales figures will be released on Monday and every auto maker is expected to post double-digit drops compared with a year earlier, according to Edmunds.com. Chrysler’s sales may show the biggest drop, with a 46% decline, followed by Nissan at 42% and General Motors  at 39%. The U.S. auto industry is expected to close out the year with numbers reflective of one of the worst in the industry’s history.

Major retailers are expected to report on Thursday that December same-store sales fell 1% during one of the weakest holiday shopping seasons ever, according to Thomson Reuters. Standard & Poor’s is more pessimistic, predicting a 2.7% decline. Certainly this bodes to be one of the weakest retail holiday seasons on record.

On Friday, the U.S. unemployment rate will be released and it is widely expected to have risen to 7% in December, the 12th month in a row that the country has lost jobs. In November, U.S. non-farm payrolls contracted by 533,000 jobs, the largest decline since December 1974, and the unemployment rate was 6.7%, the highest since October 1993.

Trading volume should begin to pick up to more normal, after holiday levels. The market has gained over 6% over the last six trading sessions and it would not surprise me to see a bit of a pullback in the next couple of trading sessions before making another  attempt to breaking some important resistance levels such as 9600 on the Dow and 1030 on the S&P 500.

Market Wrap Up 1/3/09

As we turned the page on 2008 and left behind what was the worst year for the market since 1931, the activity at the NYSE was marked by extremely low volume accompanied by some bullish enthusiasm for 2009. The first trading session of the new year featured markets rising across the board and closing at their highest levels since Nov 5^th. The major indexes, the Dow Jones Industrials, the S&P 500 and the Nasdaq were up 6.1% 6.8% and 6.7% respectively. The extremely low volume session did not impress many market participants and most say the new trading year really starts this coming Monday, January 5^th.

 

The week was not devoid of market moving events. Wasting no time after receiving bailout money from the U.S. Government, GMAC, the lending arm of General Motors, announced very attractive financing deals on new cars and trucks. The automaker is offering 0 percent financing for 60 months on several models of trucks and passenger cars. Another major corporate headline was made by DOW Chemicals (DOW) which is seeking to renegotiate a deal to acquire Rohm & Hass (ROH). The deal was put in jeopardy when the Kuwaiti government, surprisingly and unexpectedly, pulled out of a joint petrochemical deal with DOW Chemical.

 

Meanwhile over at Citigroup, high level executives and board members voted to receive no bonus compensation for the year and announced a pay plan that closely matches earnings to performance. The deal also called for Citi to recoup losses from bonuses paid to executives which were based on false or “inaccurate information.  News also came from the geo political front with the Israeli incursion into Gaza as well as the Russian state controlled gas giant Gazprom’s cutting supplies to neighboring Ukraine. Both events seemed to be brushed aside by oil traders and crude failed to loose some of its recent steam.