35 lines
1.9 KiB
Plaintext
35 lines
1.9 KiB
Plaintext
270 • The Intelligent Option Investor
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Short Investment Time Horizons
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When the scholars developing the BSM were researching financial
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markets for the purpose of developing their model, the longest-tenor
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options had expirations only a few months distant. Most market partic-
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ipants tended to trade in the front-month contracts (i.e., the contracts
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that will expire first), as is still mainly the case. Indeed, thinking back
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to our preceding discussion about price randomness, over short time
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horizons, it is very difficult to prove that asset price movements are not
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random.
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As such, the BSM is almost custom designed to handle short time
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horizons well.
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Perhaps not unsurprisingly, agents
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1 are happy to encourage clients to
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trade options with short tenors because
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1. It gives them more opportunities per year to receive fees and com-
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missions from their clients.
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2. They are mainly interested in reliably generating income on the
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basis of the bid-ask spread, and bid-ask spreads differ on the basis
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of liquidity, not time to expiration.
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3. Shorter time frames offer fewer chances for unexpected price
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movements in the underlying that the market makers have a hard
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time hedging.
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In essence, a good option market maker is akin to a used car sales-
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man. He knows that he can buy at a low price and sell at a high one, so his
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main interest is in getting as many customers to transact as possible. With
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this perspective, the market maker is happy to use the BSM, which seems
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to give reasonable enough option valuations over the time period about
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which he most cares.
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In the case of short-term option valuations, the theory describes
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reality accurately enough, and structural forces (such as wide bid-ask
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spreads) make it hard to exploit mispricings if and when they occur.
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To see an example of this, let’s take a look at what the BSM assumes is
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a reasonable range of prices for a company with assumed 20 percent
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volatility over a period of 30 days. |