The other day, I was sitting in my anti-gravity chair marveling at how beautiful and simple life truly is. I looked at my blue sky, the green grass on the hills, and the happy horses totally focused on munching hay. How simple it all seemed. And then, my mind shifted to where I used to live in a city, and I thought, “Humans and their “rational” thinking can overly complicate something as simple as life. I like my world to be simple, and I do everything I can to keep it so …
The world of trading can be as simple as buying and selling a stock or it can take us to the complex arena of options trading. To succeed in the latter requires a high-skill level and nerves of steel. Today, we will lightly venture into that world …
I see that the VIX is at multi-month lows, and I am reading from various sources that put prices are relatively inexpensive on a historical basis. However, as an example, a current quote on the September 2010, DIA 112 Put is 9.85/10.05, yet the “theoretical” value is quoted at only 7.85! How can this be? It seems to me that this option is very overpriced. Am I misunderstanding what “theoretical” value is?
My answer to your question might seem confusing, but it is the best I can do. You see, I think many traders misunderstand the role of the Black-Scholes model for determining theoretical, or fair value of an option, which is the number you need to set up your trade. Here is why … Even though there is a mathematical model to calculate the theoretical value of an option, there is often a great difference of opinion on what the actual-fair value of an option is. The key word here is “opinion.”
Just because the calculated theoretical value is X, it does not mean everyone will agree on the actual-fair value price, which is what you lament in your question to me. This happens because the originating “value” of an option derives from many factors prior to application of the Black-Scholes pricing model. Consequently, the theoretical value can change the actual-fair value depending on what factors a trader applied before the calculation to arrive at the theoretical value. The outcome of this human-oriented process is that one will often find that an option contract is higher than the theoretical price.
Some argue that using the theoretical value is not necessary, if you trade a strategy consistently, over time. This in itself will ultimately produce the fair value price. Others argue that theoretical value is the only way to successfully trade options. Which thinking is correct? The answer depends on what you believe to be correct, and if in the application of that belief, you succeed.
In the end, markets manifest from human disagreements on price. If a computer model could accurately determine fair value of an option, or any market price, than we would have no markets. The irony of this is beautiful. Theoretically, the rational certainty of mathematical computer models for market making is accurate, but without the interference of often irrational human thinking, we would have no markets. Go figure …
Trade in the day; invest in your life …
