31 lines
2.1 KiB
Plaintext
31 lines
2.1 KiB
Plaintext
Theoretical value—what a concept! A trader plugs six numbers into a
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pricing model, and it tells him what the option is worth, right? Well, in
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practical terms, that’s not exactly how it works. An option is worth what the
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market bears. Economists call this price discovery. The price of an option is
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determined by the forces of supply and demand working in a free and open
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market. Herein lies an important concept for option traders: the difference
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between price and value.
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Price can be observed rather easily from any source that offers option
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quotes (web sites, your broker, quote vendors, and so on). Value is
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calculated by a pricing model. But, in practice, the theoretical value is really
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not an output at all. It is already known: the market determines it. The trader
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rectifies price and value by setting the theoretical value to fall between the
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bid and the offer of the option by adjusting the inputs to the model.
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Professional traders often refer to the theoretical value as the fair value of
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the option.
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At this point, please note the absence of the mathematical formula for the
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Black-Scholes model (or any other pricing model, for that matter).
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Although the foundation of trading option greeks is mathematical, this book
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will keep the math to a minimum—which is still quite a bit. The focus of
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this book is on practical applications, not academic theory. It’s about
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learning to drive the car, not mastering its engineering.
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The trader has an equation with six inputs equaling one known output.
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What good is this equation? An option-pricing model helps a trader
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understand how market forces affect the value of an option. Five of the six
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inputs are dynamic; the only constant is the strike price of the option in
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question. If the price of the option changes, it’s because one or more of the
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five variable inputs has changed. These variables are independent of each
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other, but they can change in harmony, having either a cumulative or net
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effect on the option’s value. An option trader needs to be concerned with the
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relationship of these variables (price, time, volatility, interest). This
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multidimensional view of asset pricing is unique to option traders. |