38 lines
2.8 KiB
Plaintext
38 lines
2.8 KiB
Plaintext
The Intelligent Investor’s Guide to Option Pricing • 63
|
||
With this change in assumptions, we can see that the most likely
|
||
range for the stock’s price three years in the future is between about $50 and
|
||
about $70. As such, the chance of the stock price hitting $70 in two years
|
||
moves from somewhat likely (20 percent volatility in the first example) to
|
||
very likely (40 percent volatility in the second example) to very unlikely
|
||
(10 percent volatility in the third example) in the eyes of the BSM. This
|
||
characterization of “very unlikely” is seen clearly by the fact that the BSM
|
||
probability cone contains not one whit of the call option’s exposure range.
|
||
In each of these cases, we have drawn the graphs by first picking an
|
||
assumed volatility rate and then checking the worth of an option at a cer -
|
||
tain strike price. In actuality, option market participants operate in reverse
|
||
order to this. In other words, they observe the price of an option being
|
||
transacted in the marketplace and then use that price and the BSM model
|
||
to mathematically back out the percentage volatility implied by the option
|
||
price. This is what is meant by the term implied volatility and is the process
|
||
by which option prices themselves display the best guesses of the option
|
||
market’s participants regarding forward volatility.
|
||
Indeed, many short-term option speculators are not interested in the
|
||
range of stock prices implied by the BSM at all but rather the dramatic change in
|
||
price of the option that comes about with a change in the width of the volatility
|
||
cone. For example, a trader who saw the diagram representing 10 percent annu-
|
||
alized forward volatility earlier might assume that the company should be trad-
|
||
ing at 20 percent volatility and would buy options hoping that the price of the
|
||
options will increase as the implied volatility on the contracts return to normal.
|
||
This type of market participant talks about buying and selling volatility as if
|
||
implied volatility were a commodity in its own right. In this style of option trad-
|
||
ing, investors assume that option contracts for a specific stock or index should
|
||
always trade at roughly the same levels of implied volatility.
|
||
5 When implied vola-
|
||
tilities change from the normal range—either by increasing or decreasing—an
|
||
option investor in this vein sells or buys options, respectively. Notice that this
|
||
style of option transaction completely ignores not only the ultimate value of the
|
||
underlying company but also the very price of the underlying stock.
|
||
It is precisely this type of strategy that gives rise to the complex short-
|
||
term option trading strategies we mentioned in Chapter 1—the ones that are
|
||
set up in such a way as to shield the investor transacting options from any of
|
||
the directionality inherent in options. Our take on this kind of trading is that |