33 lines
2.2 KiB
Plaintext
33 lines
2.2 KiB
Plaintext
price is determined largely by the operation of algorithms called “models.”
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The original model that created the modern world of options trading was
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the Black-Scholes options analysis model, which assumed the “fair value”
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of an option could be determined by entering five parameters into the
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formula: the strike price of the option, the price of the stock, the “risk-free”
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interest rate, the time to expiration, and the volatility of the stock.
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The eventual universal acceptance of this model resulted in the derivatives
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industry we have today. To list all the forms of derivatives available for
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trading today would be to expand this book by many pages, and it is not the
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purpose of this book anyway. The purpose of this paragraph is to sternly
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warn general investors who are thinking of “beating the derivatives
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markets” to undergo rigorous training first. The alternative could be
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extremely expensive.
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At first, the traders who saw the importance of this model and used it to
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price options virtually skinned older options traders and the public, who
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traded pretty much by the seat of the pants or the strength of their
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convictions, meaning human emotion. But professional losers learn fast and
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now all competent options traders use some sort of model or anti-model, or
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anti-antimodel to trade. True to form, options sellers, who are largely
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professionals, take most of the public's (the buyers) money. This is the way
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of the world.
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Options pricing models and their importance
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After the introduction of the Black-Scholes model, numerous other models
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followed, among them the Cox-Ross-Rubinstein, the Black Futures, and
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others. For the general investor, the message is this: he must be acquainted
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with these models and what their functions are if he intends to use options.
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Recall, the model computes the “fair value” of the option. One way
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professionals make money off amateurs is by selling overpriced options and
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buying underpriced options to create a relatively lower risk spread (for
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themselves). Not knowing what these values are for the private investor is
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like not knowing where the present price is for a stock; it is a piece of
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ignorance for which the professional will charge him a premium to be
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educated about. Unfortunately, many private options traders never get |