Be your own casino: an option tutorial.
I love Las Vegas. Of course, I like lush hotels, waterfall pools, cirque du soleil acrobatics and all kinds of buffets, but that’s not what I mean. I mean I love the casino industry. This is the only business model I know based on mathematical certainty (life insurance is not far behind). Casinos know they will profit from their gambling operations (they don’t like the word gambling), because odds are always good.
Take American roulette. A betting man has 38 Numbers to choose from: 0,00, and 1 to 36. The odds of an ivory ball falling on the selected number are 37 to 1, in other words, 38 to 1. According to odds, if a gambler bets $1 on a number, he should get $38 if her number appears on the wheel. Can a casino investor actually get a $38 winning number? Noooooooo. She only got $36. The $2 deficit is the so-called “edge of the house”, equivalent to 5.26 per cent of each dollar bet. In other words, in the long run, a casino is mathematically assured that it will earn a profit of $0.0526 per dollar. In fact, the CARDS stacked up against the gamblers if they really started to win, the casinos would accuse them of cheating.
What does this gambling statement have to do with stocks? Nothing, but it has a lot to do with stock options. Before I explain the link between casino and stock options, a quick review is needed. As a fool has discussed in the past, options are contracts made up of put or put options. Give the buyer the right, but not the obligation, to sell the stock at a certain price. The call gives the buyer the right, but not the obligation, to buy the stock at a certain price. Options can also be sold. (rather than the stock paper, stock option is to create derivative contracts, the securities and exchange commission formulated the “in order to prevent the naked short selling stocks, there is no ban on naked short selling options.) Unlike the buyer, the option seller has no rights, only obligations, but pays for these obligations. The seller of the option shall have the obligation to sell the shares to the subscriber at a certain price, if the holder chooses to exercise the option. Similarly, if the voter chooses, the seller of the bet is obligated to buy the shares from the owner at a certain price.
Back to the wheel
Now back to the link between the casino and the stock options. Just as the payment of roulette is based on the probability that a ball falls on a roulette wheel, the price of a stock option is also based on the expiration of the probability of a stock landing at a particular price on the date of the option. Let’s say you’re neutral about a stock, and you want to benefit from that view. For example, you can sell the December price difference on the stock. It is best to choose a large number of trading stocks with a currency option market. The possibility of some highly mobile including Motley Fool Inside Value choose Microsoft (Nasdaq: MSFT) and Intel (Nasdaq: INTC), valero (New York stock exchange (stock code: VLO), general motors (NYSE: GM), altria group (NYSE: MO), and the stock advisor choose eBay (Nasdaq stock code: eBay).
For the sake of argument, we chose to charge $32.50 / $35 on eBay in December. Credit spreads are the simultaneous sale and purchase of two options – one sale and one purchase – with different execution prices, but with the same expiration date. I like the spread because they limit my risk. Suppose you sell a $32.50 phone and buy a $35 phone. The $32.50 phone was priced at $1.40 and the $35 phone was priced at $0.55. Your “net credit” (that is, you from the revenue generated by call options after deducting the cost of purchased options will receive cash amount) will be $0.85 for each contract (down $1.40 at $0.55) or $85 (0.85 times 100 shares per contract). When the option expires, the price of the call option is even $33.35 ($32.50 plus $0.85),
Is the net gain of selling call options at $0.85? The short answer is yes. Unlike casinos, the options market does not deter you, pricing or very close to “fair value”, as I will describe below.
In addition, I would not recommend placing any evidence in a press release that claims to have found an “undervalued” option to buy or “overestimate” a sell option. If the valuation differences do exist, so before retail investors even see any such differences, select institutions marketmakers millions of dollars of computer model will use them in milliseconds. That is to say, let me by reference to studies of 2004 Ibbotson Associates to hedge the statement of the index option prices, which found that “option writing can be very profitable.” “According to this study, certain index options (to the as the S&P 500) have historically had been overpriced. Thus, if I was forced to choose between the options being slightly overvalued or slightly undervalued, I ‘d have to choose overvalued, which, of course, favors shot (i.e. for writing) options.
Because the actual mathematics prove that fair value option is complex (anyone can say “binary tree distribution”), we need to use computer and option valuation software to determine the December option in the eBay closed below $33.35 the probability of the deadline. Please remember, in the options market pricing and valuation, even the best option valuation model is based on the estimate of the future stock volatility (and dice game is to determine the probability of dice), which in turn is “fair value” these estimates may be wrong. Even so, professional traders risk millions of dollars each day on these models, so they have to be fairly accurate in the long run.
The rule of thumb is based on the option evaluation software I use, and the probability of eBay closing at $33.35 when the option expires in December is about 65.6 percent. A simple rule of thumb can be used to verify that a net income of $0.85 is a reasonable price and the probability of success is 65.6%. Is fair for a price of $0.85, the received credit divided by the exercise price difference shall be equal to the probability of the above shares closed at $33.35 ($0.85 = $2.50, or 34%), so eBay closed at $33.35 following the fair value of the probability option expires in December at a rate of 66% (100% minus 100%).
I should stress that the rule of thumb should never be used when investing in the options market. Always rely on reliable options to analyze software calculation probability. After all, the rule of thumb is considered the rule of thumb, because it is usually reliable, but not always. However, if the probability of the rule of thumb is not similar to the probability of software generation, there will be some strange phenomena, and I may transmit this particular difference.
So you have the fundamentals of the option spread, the trading and the associated probabilities. In the second part of this series, I’ll explain how we assume that eBay’s credit spreads make you money. Stay tuned.