Episode I.

Is there a Trekkie out there who can help me out?  I understand the Black-Scholes option pricing formula, but I just can’t comprehend Star Wars.

People with tents sleeping in line waiting to buy tickets to a movie.  Not just any movie, but a movie that’s playing everywhere.  Multiple theaters, gobs of seats, and plenty of screenings.

I have a few thoughts as to why anyone would go through all the trouble to be among Star War’s first viewers.

Crowd Mentality!  The media hypes the movie, and a feeding frenzy begins.

Bad Math Skills!  Until there’s a scarcity of theaters, there’s no scarcity of seats.  Each theater has hundreds of seats, one per person.  Don’t forget they empty the theater and show the movie again.  Over and over, infinitum.

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Bragging Rights!  Every time a day one viewer watches the video, he will remember he’s able to tell his grand kids he saw the movie on May 19th not May 20th.

Bad Business Skills!  Who is smarter?  The guy in a tent for a week, or his buddy who pays him $20 to buy an $8 movie ticket?

Too Much Free Time!  Hello, don’t people have anything better to do than wait days to buy a ticket to a movie?

Am I missing something?  I just don’t get it.  While you’re at it, explain to me how Episode One can come 20 years after the first movie.

I haven’t seen the movie yet, was it worth the hype?  Was the expectation greater than the event?

What does this have to do with option pricing?

I get e-mails from many mathematically challenged, crowd following option traders who don’t know the value of time and can’t brag about good trades.  Besides, even I have to jump on a bandwagon every once in a while.

Don’t forget the suspense.  Our last column ended in a cliff hanger.  Will the sequel be worth the hype?  Does understanding Implied Volatility and Vega help traders to win more often and lose less frequently?

Enough excitement, back to option pricing.

In mathematical equations you solve for the unknown.  Two plus two equals what number?  That’s too easy.  Let’s use multiplication instead of addition.  Two times two equals?  Still too simple, how about option pricing?  Without going into tremendous detail of option pricing formulas, here’s the gist.

The price of the stock compared with the strike price has a value.  The amount of time to expiration is easily calculated.  As are interest rates and dividends.  You take all these components plus the expected volatility, plug them into the pricing formula, and solve for the unknown; the option’s price.  Actually the option’s theoretical price.

While mathematical formulas determine theoretical value of options, market forces determine the price at which options trade.  The market consists of buyers and sellers.  Supply and demand.

More buyers equals higher prices.  You can’t pitch a tent to be one of the lucky, you need to write a check.  On the flip side of the coin, excessive sellers and/or insufficient buyers drive prices lower.

Market Makers estimate with formulas.  Charging according to whatever the traffic will bear.  If the market won’t support higher prices, it drops.

The Dark Side of the Force.

Back to our make believe world, where nothing changes unless we allow it.  Without any movement to the stock price, interest rate, dividend, and time to expiration; the price of an option can still vary.

The funny thing about all our previous make believe examples, this one might not be so made up.  In reality, an option’s price may fluctuate without any other circumstantial difference.  This situation can happen.

A rumor may spread about a take over possibility.  The interest rates and dividends could certainly remain the same before and after the rumor.  The stock price might not move.  In no time at all the price of the options could sky rocket.  The hype could end just as sudden and the stock price not falter, but the option price melts.  Could it be, the expectation was greater than the event?

What about earnings reports?  After the announcement, there is no guess work, no unknown, no expectation.  Option prices tend to drop, the sizzle is gone and all that is left is steak, or gristle.  Don’t fuel the fire by over paying for options.

Comparing Implied Volatility to Expected Volatility tells if an option is fairly valued.  If the Implied Volatility is less than Expected Volatility the option is said to be undervalued.  If Implied Volatility is greater than Expected Volatility the option is overvalued.

Vega measures option price changes based on volatility.  Although Vega is considered one of the “Greeks,” it’s not actually Greek.  It’s Spanish.  Or as most would say, A foreign language.

“May the Implied Volatility be with you.”

 

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