Search the Community
Showing results for tags 'options pricing'.
Found 1 result
The logical response is no. Because options are derived from the underlying, how can the opposite also be true? It is the same rationale as the observation that wet sidewalks do not cause rain; even so, many traders believe there is a direct impact of options on the underlying. There is a degree of observed cause and effect, but logic should prevail. The most often cited example of how options cause stock prices to move is that if pinning. Stock prices tend to move toward the closest option strike just before expiration (this is called pinning to the strike). This is a temporary outcome of trading in stocks taking place with option expiration prices in mind, notably on the part of covered call writers. Is this an example of options causing stock prices to move? No. It is only an example of trading behavior in the stock, based on proximity between stock price and option strike. It is a temporary occurrence and is strictly caused by underlying trading, not by options. The rationale for believing that options affect underlying prices, is based on the argument that when interest in options grows, it must translate to a greater interest in the underlying. This sounds reasonable, but it is not necessarily true. Most traders realize that there are two types of options traders. First is the covered call writer, a conservative trader who accepts limited maximum profit in exchange for low risk. Second is thew speculator, who is likely to trade in options without taking up an equity position. This is not always a high risk approach to trading. By entering strategies with offsetting positions, risks can be limited. But the question remains: Do either of these general categories of traders affect prices of the underlying? The covered call writer is not always interested in keeping the equity position for the long term and might be more than willing to have 100 shares called away if the strike price is greater than the trader’s basis in stock. There is no observable cause for the covered call to make the stock price behave in any way beyond possible pinning as a temporary matter. Speculation cannot affect stock prices either, because it normally is limited to trading in option contracts and not in any equity position, either long or short. Even so, some traders fall into a logic trap, considering some combinations as equivalent to stock positions. For example, synthetic positions mirror stock price movement on a point-for-point basis. A synthetic long stock trade consists of a long call and a short put and is likely to be set up with close to zero cost (or even a small net credit). A synthetic short stock trade combines a long put and a short call and performs best when the stock price declines. Both forms of synthetics involve the same strike for both sides, usually at or as close as possible to the current price of the underlying. It is worth remembering, however, that a synthetic position is not the same thing as a long or short position in the stock. It is a “side bet” on how stock price will behave between entry date and expiration. A synthetics trader is likely to realize a profit from decline in time value, alone or in combination with increases in long position intrinsic value. Neither of these affect behavior of the stock itself. An enlightened view of synthetics is that the pricing of each option is independent of stock price behavior. Those option prices will either benefit from stock price changes or be harmed – all depending on which direction the underlying moves. But despite the belief that positions like synthetics directly impact stock price behavior, there is no logical basis for accepting that idea. Options activity has no impact on supply and demand for shares of the underlying. Even implied volatility of options is remote from stock price behavior. It is an estimate of how options volatility might evolve in the future. However, implied volatility cannot affect the price of the underlying (or, for that matter), the price of the option). As an estimate only, it is not a reliable means for measuring the underlying. For that, only historical volatility works. The belief that implied volatility has any impact on the underlying makes no sense whatsoever. Historical volatility is related to recent stock price behavior and may also be reflected in changes in the fundamentals of the company (earnings, dividends, and working capital, for example). None of the fundamentals have any relationship to options pricing, and certainly are not affected by options trading. The true impact of options pricing is limited to intrinsic and time value and varies as moneyness changes positions. Once again, pinning comes into play in some cases, but only as a temporary behavior among traders in the underlying, whether they also trade in the options. Moneyness becomes a matter of interest at specific moments, such as the period right before ex dividend date or earnings announcements. However, these events are related to the company (fundamentals) and stock price behavior (technical) but are not caused or changed by options volatility or proximity to expiration. Some traders attempt to equate option pricing based on measurements of delta, attempting to prove a correlation between the option and the underlying. But even if this can be accomplished to some degree, what does it prove? Delta is not what causes stock prices to rise or fall. In fact, changes in Delta may occur with price movement in either direction. Just as volatility of the options does not cause stock prices to move, Delta is not a related factor. Options do not impact stock prices. It is the opposite, the derivative affect of the underlying on the resulting value of the option. There is no magic involved, just logical observation. 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 website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.