Strategy
As a trader in equity options, you should be valuing
the underlying stocks. Use fundamental analysis and
technical analysis.
Also watch Put-Call ratios. When there are many more
buyers of Calls than Puts on equities, the Put-Call
ratio is low, but you can expect, more often than
not, a reversal leading to a market decline. Conversely,
when investors are buying Puts and the Put-Call ratio
is high, you may expect Call buyers to emerge and
the market to rise again.
When you buy, select those options on shares and indices
that are volatile enough to provide a good chance
of the big move in your favour. It means paying more
for the option.
Generally, options are more expensive when interest
rates are in decline because investors are then willing
to withdraw cash from deposit accounts for trading
purposes. To reduce your risk in trading, you can
buy options on a variety of securities and they can
be both Calls and Puts.
Black–Scholes
Buyers and sellers ultimately set the price of an
option, but it is City traders who value it. One of
the standard ways is through the Black–Scholes
model, which is based on the work of two US academics,
Fisher Black and Myron Scholes. The model was first
published in 1973 and it uses a complex mathematical
formula, taking into account the intrinsic value and
time value of the option and the fact that it does
not pay dividends. A limitation of Black–Scholes
is that it assumes that the stock price moves randomly
because it reflects the full knowledge and expectations
of investors. This is in accordance with the efficient
market hypothesis, which is widely disputed.
Black–Scholes was a basis for some aggressive
derivatives strategies of Long Term Capital Management
(LTCM), a hedge fund founded by ex-Salomon Brothers
trader John Meriwether, and Myron Scholes was one
of its main shareholders. When asked whether he believed
in efficient markets, Meriwether furiously replied:
‘I make them efficient.’
It worked in the early days. In 1995, LTCM gave shareholders
a 42.8 per cent return and, in 1996, a 40.8 per cent
return. In 1997, it had more than halved to 17.1 per
cent, which was still very healthy but, in 1998, the
fund failed and the US Federal Reserve bailed it out.
It is unfair to blame Black–Scholes for the
collapse because LTCM had operated on a large enough
scale to make it untypical, according to the pundits.
The City still believes in Black–Scholes but
sometimes modifies it. Traders exploit anomalies in
options priced according to the model.
Online learning and research
So far, we have looked briefly at how options work,
and have covered the important points. If you decide
to explore options further, the internet is your friend.
Surf selectively because many sites on options try
to sell you software or courses.
Visit The Futures and Options Association, the industry’s
trade body, at www.foa.co.uk, and download high-quality,
free material.
It is worth visiting the Chicago Board Options Exchange
at www.cboe. com. The site has useful free educational
material.
