Option Pricing

As you have searched the website hoping to obtain the Best Options Trading for Dummies, this option pricing article could be sensible, especially after having lost money due to risk management failure when exposing to options.

We look at how money could be made trading options by analyzing option pricing mechanism.

Revisit the Factors affecting Option Pricing

There are six factors affecting the option pricing:

  1. The current price of underlying asset
  2. The option strike price
  3. The time to expiry of the option
  4. The price volatility of underlying asset
  5. The risk free interest rate, or whatever funding rate the writer of option incurs
  6. The expected dividends of underlying asset during the life of the option

However, that’s where the theory of option pricing ended moved on to become more of an art than a science. The one who fully appreciates the masterpiece shall avoid losing money trading options as one understands option pricing mentality.

My argument is that option pricing and valuation comes with well establish formulas like Black Scholes and Merton, but the key to option pricing is based entirely on market knowledge of the option writer.

How Option Pricing make money trading options for dummies?

There are many theories on options setup strategies, like spreads, straddles, strips, straps, strangles and other exotic complex derivatives of the earlier mentioned fundamentals. The options writers sell these options to willing buyers in the market.

The option writer made cash from the buyer while the willing buyer loses cash but bought into a risk or a risk mitigation strategy. The risk occurs when the buyer buys naked (i.e. when buyer doesn’t intend to hedge against portfolio, but seeks capital gain)

The option buyer will make cash when underlying asset price movement exceeded strike price of the option in the correct direction, after covering for premium paid for option and the theoretical cost of money.

If both sides made money, then who loses money? All market participants want to make money, no? The hint here is for option buyers to look for option writer(s) who made errors and buy into them, while option writers entice gullible buyers to buy their option. Unfortunately, in the normal case option buyers should lose money.

The moral of story, believe anybody when they promise you making money trading option for dummies at your own risk, because they forget to remind you about losing money from trading option.

Making the Market by Option Pricing

Options are generally illiquid product as only punters and experts participate in them. The market maker has duty to ensure correct pricing of options by artificially creating a buy and sell queue.

Unwritten rules in Option Pricing

There are many mathematical models used for option pricing. This introduction will not discuss into these models other than to mention that common models in use included risk neutral pricing, binomial model, black scholes merton model or other in house models.

If we study slightly further into these models, we shall understand that these models based on certain underlying assumptions that could be fundamentally flawed applied to the real world.

Remedial Actions if Options Pricing Model is wrong

We learn from above that option writers have at least 2 tools of the house. These 2 tools are summarized as

  1. Market making initiative
  2. Options pricing initiative

The one that holds the initiative in a battle has higher probability of going in for the kill. Meaning, option writer will price their options with larger implied volatility than the normal trading range, maybe up to a 99% confidence interval that volatility will never be traded.

The option writer can also make the market to their advantage by slippage of tracking or in bid offer spread.

All is not Lost

The option writer has to ensure that at least there are counterparties for meaningful profit making. The risk is that there may be no buyer for the option, but all is not lost for option buyers!

The option seller has to price this derivative at a more reasonable level, say, an implied volatility of 54% to entice option buyers. The price at this level could be sufficient to entice the highest risk group of buyers buying in hoping for a quick buck, we call them punters, the others could be hedgers.

Conclusion

In conclusion, there are six factors affecting options pricing, these factors cuts both ways, but are disadvantage to even the best options trading for dummies novice option buyer. Furthermore, there are another two factors that affects options pricing in a manner that skew the playing field to the option writer.

  1. Appears to be slower a market making?
  2. Accidental widening of bid offer spread?

In total, house 8 and buyers 6, the casino never loses. Good luck trading best option trading for dummies.

Hope that this article at Best Options Trading for Dummies sheds some light to the unwritten rule on analysing option pricing. As your market knowledge increase, your mental model shall improve and lead to understanding of option pricing beyond theoretical. Thats where money comes in for a reason other than random chance because you understand the unwritten rule of option pricing.