This post is moderately advanced, so if you do not understand terms within this post please see the mentioned books. The first part of this series will discuss the role of volatility in options pricing, and where volatility fails to accurately price options.
Having read through "Security Analysis," I noticed a brief section on warrants, but otherwise there was a lack of perspective on how to value options. Just as the Efficient Market Hypothesis has made value investing possible with equities, so too has the Black-Scholes model compounded the number of opportunities available with options.
The first thing you must understand is that, in general, you look for mis-priced equities first, and only then do you evaluate whether alternative opportunities are present in the form of derivatives/warrants/convertibles/etc. The second things you must understand about options is that the bulk of the price premium that you pay over the current market price of an equity comes from volatility of the underlying equity.
Without getting too complicated, the inputs that go into pricing options include the time to expiration, the current risk free interest rate, the difference between the strike price and the current price, and the volatility of the underlying stock. For a thorough explanation of volatility and the role it plays in option pricing, I recommend "The Volatility Edge in Options Trading" by Jeff Augen.
Historical Volatility, is a number which measures how much the stock has moved around over a fixed historical time period. Implied volatility is derived be taking the current price of options and using the Black-Scholes model to solve for the volatility. Of all the variables that go into options pricing, volatility is the only variable that is squared, i.e., a small change in volatility has a large change on the options price.
For near term expiration, volatility does a pretty good job of pricing options. Chances are, that if the stock moved up or down a certain amount last week, that on average, it will do the same next week. This is even true for undervalued stocks, because it takes the market time (months to years) to realize the value of the underlying equity. The problem, then, comes from using the Black-Scholes (and the derived volatility) model to value long dated (six month or more) options. This is because using volatility to price options tends to give an equal probability for upward or downward movement. We know from following the philosophy of value investors that stocks tend to reach their intrinsic value over time.
In "The Dhando Investor" Mohnish Pabrai mentions that he has noticed anecdotally that the intrinsic value of an equity is reached on the order of 1-3 years. Because of put-call parity, the implied volatility of calls and puts must be equal (or at least pretty close), which means that even long-term options give the same probability of downward movement as upward movement.
Taking the above into account means that we are much more likely to find mispriced long-dated options than short-dated ones. So after having run a screen for undervalued equities, the first criteria I search for are equities for which LEAPs are available.
Please visit my blog, The Doctor Investor.
Having read through "Security Analysis," I noticed a brief section on warrants, but otherwise there was a lack of perspective on how to value options. Just as the Efficient Market Hypothesis has made value investing possible with equities, so too has the Black-Scholes model compounded the number of opportunities available with options.
The first thing you must understand is that, in general, you look for mis-priced equities first, and only then do you evaluate whether alternative opportunities are present in the form of derivatives/warrants/convertibles/etc. The second things you must understand about options is that the bulk of the price premium that you pay over the current market price of an equity comes from volatility of the underlying equity.
Without getting too complicated, the inputs that go into pricing options include the time to expiration, the current risk free interest rate, the difference between the strike price and the current price, and the volatility of the underlying stock. For a thorough explanation of volatility and the role it plays in option pricing, I recommend "The Volatility Edge in Options Trading" by Jeff Augen.
Historical Volatility, is a number which measures how much the stock has moved around over a fixed historical time period. Implied volatility is derived be taking the current price of options and using the Black-Scholes model to solve for the volatility. Of all the variables that go into options pricing, volatility is the only variable that is squared, i.e., a small change in volatility has a large change on the options price.
For near term expiration, volatility does a pretty good job of pricing options. Chances are, that if the stock moved up or down a certain amount last week, that on average, it will do the same next week. This is even true for undervalued stocks, because it takes the market time (months to years) to realize the value of the underlying equity. The problem, then, comes from using the Black-Scholes (and the derived volatility) model to value long dated (six month or more) options. This is because using volatility to price options tends to give an equal probability for upward or downward movement. We know from following the philosophy of value investors that stocks tend to reach their intrinsic value over time.
In "The Dhando Investor" Mohnish Pabrai mentions that he has noticed anecdotally that the intrinsic value of an equity is reached on the order of 1-3 years. Because of put-call parity, the implied volatility of calls and puts must be equal (or at least pretty close), which means that even long-term options give the same probability of downward movement as upward movement.
Taking the above into account means that we are much more likely to find mispriced long-dated options than short-dated ones. So after having run a screen for undervalued equities, the first criteria I search for are equities for which LEAPs are available.
Please visit my blog, The Doctor Investor.
