This segment deconstructs option modeling enabling those who view it to gain a better understanding of the role of volatility in pricing and to make choices which can increase their return on capital for the same relative risk. This should be of interest to all options traders.
An ATM call on a $100 stock will be 2x the price of an ATM call on a $50 stock, and 1/2x the price of an ATM call on a $200 stock all other things being equal (like days to expiration, volatility, carry costs). A slide showed an example of this. This is also true of calls and puts that are equally OTM.
The option price is derived from the cost of the shares to delta hedge the option and a loan to pay for those shares. A slide showed the formula for this. It is not necessary to understand the math so much as to understand the concept. The former may be tough for some but the latter is relatively easy.
The price of the option increases as the cost of the hedging shares increases. This can be seen in live data. TP did a search for two stocks with the same IV. He came up with Micron and Weatherford which are very different. The ratio of their stock prices though equalled the ratio of their ATM straddles.
What this also means is that the price of the option is the same percent of the stock price. Because the margin on a naked short option is based on the stock price, for stocks with similar volatility the choice should be made only considering account size and liquidity.
When the IV of two stocks is different, comparing the ratio of their straddle prices to the ratio of their stock prices can put the volatilities into a different context. Comparing them this way shows that the difference in premium is really due to volatility and stock price is just a number. A slide was shown demonstrating this using SPY and QQQ as examples.
The price ratio of SPY to QQQ would equal the ATM straddle ratio if IV was the same. Because the straddle ratio is less, we can see that the QQQ straddle is relatively more expensive (or SPY straddle relatively cheap) because of QQQ’s higher IV. Going further, we see that the QQQ straddle 4.17% of the stock price which is greater than the percent that the SPY straddle is (3.56%) and by an amount greater than the difference in IV. That could give the QQQ straddle slightly higher return on capital for the risk.
Another choice is to apply beta and the lesson from the 7/29/15 Skinny on Data Modeling. When the correlation between two stocks is high and consistent, and the ratio between the straddle-to-stock percentages does not reflect the beta between the two stocks, it’s possible to get a higher return on capital relative to the risk of the short option.
Watch this episode of "The Skinny On Option Modeling" with Tom Sosnoff, Tony Battista and Tom Preston for a better understanding of the role of volatility in options pricing which should help your trading.
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