The Need for Speed with Option Trading

The Need for Speed

What causes an option to have a speed component to its price? The quick answer is that it has to do with the fact that options have a time premium. The bigger tire time premium, the further the stock must move to recoup the cost. But that begs the question why do options have a time premium? In order to understand why options, have a time premium, consider the following similar­ity of a football bet.

Imagine that you are betting on this year’s Superbowl between the New England Patriots and Philadelphia Eagles. You do your homework and find that all of the analysts are predicting that New England will win. To the unwary, this high probability outlook sounds like it is too easy to make money; all you have to do is bet big on New England and you’ll walk away richer. But if you attempt this, you’ll quickly find it is not that easy. The reason is that everybody is reading and acting on the same information and the crowd will want to bet on New England too. That means you now have a problem since you cannot find any­body to take the other side of the bet.

How can you entice someone to take the other side; that is, to bet on the Eagles? One of the easiest is to offer a point spread. While nobody is willing to bet on the Eagles in actual points (or “even up”), people will take the bet if you create a point spread. For instance, if you offer someone a 7-point spread that means you must subtract seven points from the Patriots score before compar­ing it to the Eagles score (or, equivalently, anybody betting on the Eagles gets to add seven points to their score). This acts as a handicapping system thus making it more difficult for the Patriot bettors to win. If the Patriots win 21-14, there is exactly a 7-point spread (the difference in scores) and no money is won or lost. A bigger difference in scores results in a win for the person betting on the Patriots while a smaller spread results in a win for the one betting on the Eagles.

How is tine spread determined? It is determined by the market. If a bookie posts too low of a point spread then nobody will be swayed to betting on the Eagles. If the point spread is too large, then everybody will wish to bet on the Eagles. It’s only when the point spread is just right - the market price - that bookies will find an equal number of buyers and sellers and all bets can be placed. Only when you have a balanced number of buyers and sellers can the bet be viewed as fair; the crowd is indifferent between betting on one side or the other.

Now, if you just think of an option as a directional bet on the stock, let’s see how this football analogy relates to the options market. If everybody thinks that VIP stock’s price will rise, then everybody would want to buy call options. In other words, nobody would be willing to sell those calls. That is, nobody will sell the calls unless you offer a point spread on the bet. The spread on an option is somewhat hidden but it is easy to show that it is there. Figure 1 shows that the $31,625 call was asking $3.50. Any trader who buys this option and exer­cises it will have a cost basis of $31,625 + $3.50 = $35,125 on the stock. However, the trader could have elected to buy the stock at the current price, which gives him a cost basis of $31.41. So the trader who buys the call needs the stock price to move to $35,125 just to break even at expiration.

In essence, anybody buying this call is really betting on something more than that the stock will rise. The buyer of this call is really betting that the stock’s price will be above $35,125 by expiration since that is the breakeven point on the option. The stock buyer is really betting that the stock’s price will be above its current price of $31.41 whereas the call buyer is betting that the stock’s price will be above $35,125. And those are two very different bets.

Since the current stock price is $31.41, there is effectively a $35,125 - $31.41 = $3.71 spread on the “bet” at this time. This spread acts in the same way a point spread does for our earlier football example bet. It is only because of this $3.71 point spread that a market between buyers and sellers could be created. If the time premium was higher than $3.50 on that call then we would have too many people wanting to sell the bet and the price would fall. If the premium were less than $3.50 then we have too many people wanting to buy the bet and the price would rise. At a price of exactly $3.50, the number of buyers and sellers is balanced at that point in time and the bet can be viewed as fair.

Notice that, at expiration, if the stock rises to $35,125 or less, any trader who paid $3.50 for the $31,625 call loses the bet - even though the stock’s price rose. Using the football analogy, you would lose the bet if the Patriots win by less than the spread. Even though you picked the correct team to win, you still lost the bet since they did not win by a big enough spread. And this is exactly what happened to the traders who bought any of the VIP calls in Figure 1 and tried to sell thirteen days later. Although traders buying the call were correct on the stock price direction, they accepted too big of a point spread on the bet.

Hopefully, you are now convinced that volatility matters. Yet most option traders do not take it into account when assessing the value of a trade. So how does a trader account for the volatility? That is where the Black-Scholes Model comes into play.