SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

CAPM As an Alternative Option Pricing Model


Options traders endlessly debate the merits of the Black-Scholes pricing model. Some swear by it and others don’t even try to use it. Given the many profound flaws in the model, it is not an accurate tool for developing a sense of where price is likely to move in the future. But there are alternatives.

Among these is growing popularity of focus on the fundamentals (profitability, capitalization, debt management, competitive strength, and dividends, for example). But this is twice removed from the option and its premium level. It is removed because the difference between a company’s fundamentals and its stock price is different in terms of timing as well as in what types of volatility are considered. Historical volatility is easier to track that the option’s implied volatility, and in fact the two calculations are nothing like each other.

Historical volatility is a summary of the stock price itself and, because it is based on what has occurred in the past, it is exact and precise. In comparison, implied volatility is an estimate of future premium levels based on estimates of many factors, notably of volatility itself. The outcome can be easily manipulated by changing the assumptions used in the calculation. Some traders may even argue that when historical volatility is available, there is no need for implied volatility. The option is a derivative stock prices and volatility, and accordingly, varies in value and risk based on how the stock price behaves (breadth of trading).

 

One study downplayed the value of IV, noting in a study that “we found that implied volatility contains no more information regarding the future realized volatility that is not already contained in recent historical volatility.” [Kalyvas, Lampros and Nikolaos (2003). “Casual relationship between FT-SE 100 stock index futures volatility and FT-SE 100 index options implied volatility.” Journal of Financial Management & Analysis 16(1), 20-26]    
 

Inaccuracy is at the core of why IV is not reliable for pricing options. An alternative is found in the use of the Capital Asset Pricing Model (CAPM). This method compares expected returns with the risks. This risk/return analysis makes greater sense that relying on a model with many variables and flaws. This does not mean CAPM is perfect; it does mean it allows you to make judgments base don varying attributes of the option itself. If you look only at expect return or only at risk, you lack a complete picture. This is where CAPM adds value.
 

Expected return is the return you expect to ear n and, at least for stock trading, is a relatively simple calculation. It may consist of current dividend yield and assumed future yield growth, added to expected stock price changes. For ex ample, if the past three years have seen a 0.5% increase in dividend yield and stock prices have risen by 4% per year, it makes sense to continue the calculation of expected return assuming the same rate of growth will apply in the future. [Bernstein, Peter. L. (May 1973). “What rate of return can you ‘reasonably’ expect? Journal of Finance 28 No. 2, 273-282]
 

To complicate the calculation but add reliability, some other features can be added to the calculation. In the following formula, ‘R’ is the realized result and the total in the range of ‘R’ is equal to 100%:

             ( P1 + R1 ) + … ( Pn + Rn ) = E

            Where P1 = outcome # 1

            Pn = final outcome

            R1 = realized result # 1

            Rn= final result

            E = expected return

 

For options, the range of likely expected results is more complex than for stocks, given the range of likely outcomes. A stock has a large number of possible prices, but the option is affected by many more variables, including time and expiration as well as the extrinsic nature of volatility itself. For this reason, you need to estimate a range of likely returns that are simplified.

For example, assume returns will range from 100% profit to 50% profit, breakeven, 50% loss, or 100% loss. This reduces the range to five outcomes and, while not accurate will enable you to compare expected return for a range of different option trades. This range can then be reduced to a percentage-based set of outcomes:

  • 100% profit at realized result estimated at 20%
  • 50% profit at realized result estimated at 30%
  • breakeven at realized result estimated at 15%
  • 50% loss at realized result estimated at 10%
  • 100% loss at realized result estimated at 25%

 

The highest level in this arbitrary range is 30% for a 100% loss. This may be based on history of not cutting losses before expiration and the 50% profit is greater than 100% profit because traders may tend to take profits earlier than originally planner due to time decay. To calculate expected return based on these estimated outcomes:

 

       (100% * 20%) + (50% * 25%) + 0% * 15%) + (-50% * 10%) + (-100% * 30%) = -0.025%

 

Thus outcome is less than zero, so you would be compelled to adjust expect return in several ways. These include picking contracts with higher than average returns (increasing the risk); writing covered short positions high exceptionally high dividends (increasing returns); adjusting profit-taking and loss-cutting (holding positions for shorter times); or deciding whether strategic alternatives produce higher levels of profitability (improving selection of strategies).
 

As long as assumptions are realistic, calculating expected returns with CAPM is beneficial. Many traders already do this type of judgment or assessment instinctively and based on experience, without needing to write out a formula.


Two variations of the CAPM method may also be considered. These are the Treynor-Mazuy Measure which adds beta into the formula; and the Sharpe Measure which relies on standard deviations of net returns. These are compared in the next article in this series.
 

CAPM, like all methods for estimating returns, contains flaws. Its major advantage over Black-Scholes is that it does not rely on estimates of volatility, which is where many problems arise in trying to develop reliable pricing models.
 

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Options on Options

    Traders have long known that options can be opened on many different securities. Among the most ingenious of these are options on options. There are four types of these: call on a call (CoC), a call on a put (CoP), a put on a call (PoC), and a put on a put (PoP).

    By Michael C. Thomsett,

    • 0 comments
    • 223 views
  • The Wheel Trade

    The “wheel” trade is variously described as a beginner’s strategy, a combination to exploit features of both calls and puts, and as “perfect” solution to the well-known risks of shorting calls, even when covered. The wheel could be defined as any of these, but a larger question should be: Is the wheel an elegant method for making profits consistently, or just a gimmick?

    By Michael C. Thomsett,

    • 0 comments
    • 517 views
  • Chooser Options

    Most options traders see their world as a choice between calls or puts, alone or in various combinations. But there is more. With a chooser option, traders can open a position and decide later whether it will be a call or a put. This is also called an as you like it option.

    By Michael C. Thomsett,

    • 0 comments
    • 446 views
  • Leveraged Anchor 2020 Year In Review

    Steady Options has now been trading the Leveraged Anchor strategy for two years, and, somewhat to my surprise, 2020 went even better than 2019. On the year, Leveraged Anchor was up 31.7%, while the total return of the S&P 500 was 18.4%.

    By cwelsh,

    • 2 comments
    • 1,247 views
  • Ratchet Options

    The “ratchet option” is so-called because as a series, each successive position activates when the previous option has expired. The trader ratchets up (or down) to the next position. Each one is set up to be as close to the money as possible. It has many names, including cliquet, moving strike, ladder, lock-in, or reset option.

    By Michael C. Thomsett,

    • 0 comments
    • 467 views
  • Steady Momentum 2020 Year in Review

    Steady Momentum Put Write (SMPW) is one of the available subscription services at Steady Options. We launched the strategy in early 2019, so we now have two years of performance to evaluate on both an absolute basis and relative to the strategy’s benchmark, PUTW (WisdomTree CBOE S&P 500 PutWrite Strategy Fund). 

    By Jesse,

    • 0 comments
    • 450 views
  • SteadyOptions 2020 Year In Review

    2020 marks our 9th year as a public trading service. It was an excellent year for us. We closed 130 winners out of 194 trades. Our model portfolio produced 117.1% compounded gain on the whole account based on 10% allocation per trade. We had only three losing months in 2020. 

    By Kim,

    • 0 comments
    • 730 views
  • The Jump-Diffusion Pricing Formula

    One of the more complex areas of options analysis involves pricing formulas. The best known among these is the Black Scholes Model (BSM). This is a widely cited method for attempting to determine what the option’s premium should be, but it is deeply flawed.

    By Michael C. Thomsett,

    • 0 comments
    • 493 views
  • Ranges of Exotic Options

    The standard call and put are well known to all option traders, but many exotic and more advanced options can also be opened. Whether a specific broker allows trading in these, and whether a trader has the necessary trading level, are questions to be addressed. This article just defines many of the exotic options that are possible.

    By Michael C. Thomsett,

    • 0 comments
    • 573 views
  • What To Do Before Committing To Trading

    Trading cryptocurrency has become a very popular and significant part of life. While it’s not for everyone, it’s certainly for an awful lot of people. There’s money to be made and areas to be invested in, and people will do what they can to make either a quick buck or an amazing figure.

    By Kim,

    • 0 comments
    • 732 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido