35 lines
2.4 KiB
Plaintext
35 lines
2.4 KiB
Plaintext
Finding Mispriced Options • 147
|
||
the near at-the-money (ATM) strikes were the most active because of the
|
||
two far OTM options that traded; one’s price didn’t change at all, and the
|
||
other went up by 1 cent. On a day in which the underlying stock fell, these
|
||
calls theoretically should have fallen in price as well (because the K/S ratio,
|
||
the ratio of strike price to stock price, was getting slightly larger). This just
|
||
shows that sometimes there is a disconnect between theory and practice
|
||
when it comes to options.
|
||
To understand what is probably happening, we should understand
|
||
something about market makers. Market makers are employees at bro-
|
||
ker-dealers who are responsible for ensuring a liquid, orderly securi-
|
||
ties market. In return for agreeing to provide a minimum liquidity of
|
||
10 contracts per strike price, market makers get the opportunity to earn
|
||
the bid-ask spread every time a trade is made (I will talk about bid-ask
|
||
spreads later). However, once a market maker posts a given price, he or
|
||
she is guaranteeing a trade at that price. If, in this case (because we’re
|
||
dealing with OTM call options), some unexpected positive news comes
|
||
out that will create a huge rise in the stock price once it filters into the
|
||
market and an observant, quick investor sees it before the market maker
|
||
realizes it, the investor can get a really good price on those far OTM call
|
||
options (i.e., the investor could buy a far OTM call option for 1 cent and
|
||
sell it for 50 cents when the market maker realizes what has happened.
|
||
To provide a little slack that prevents the market maker from losing too
|
||
much money if this happens, market makers usually post prices for far
|
||
OTM options or options on relatively illiquid stocks that are a bit unrea-
|
||
sonable—at a level where a smart investor would not trade with him or
|
||
her at that price. If someone trades at that price, fine—the market maker
|
||
has committed to provide liquidity, but the agreement does not stipulate
|
||
that the liquidity must be provided at a reasonable price. For this reason,
|
||
frequently you will see prices on far OTM options that do not follow the
|
||
theoretical “rules” of options.
|
||
Bid-Ask
|
||
For a stock investor, the difference between a bid price and an ask price
|
||
is inconsequential. For option investors, though, it is a factor that must
|
||
be taken into consideration for reasons that I will detail in subsequent |