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I understand that expected price changes of underlying assets are usually priced into options, but I don't understand how.

For instance, before upcoming earning reports the option values are inflated to a point that represents any potential profit from an earnings price jump or decrease in the underlying stock.

I dont understand how people interpret the "street estimates" to price the options. I would appreciate any insight into this and I'm not just focusing on earnings reports

for instance, if I believed a stock was going to drop 10% and nobody else did, I would still be unable to convince a market maker to accept my order for options at double their value - yet. I would have to buy and buy and buy and buy until the options were inflated in value that much, and that only happens if large parties or everyone expects a move like that.

Options pricing isn't an exact science, but any insight or empirical analysis would be greatly appreciated

(I am 100% sure that this question doesn't belong on the basic personal finance site)

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I would agree that the question doesn't really belong on personal finance, but I don't see how it belongs here, either. Isn't the answer to your question simply that market participants try to guess at it and, collectively, the market aggregates their guesses and come up with a pretty decent price which incorporates the expected moves? –  Tal Fishman Dec 26 '11 at 4:27
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5 Answers

Trading following earnings tends to follow a bimodal normal distribution. There is an expectation the stock will jump or fall some 'x' % amount based on an underlying bimodal normal distribution. Calculate the expected value

It's like a dividend

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You have to think about options prices and expected moves 'backwards'.

Option prices imply what the expected moves are. Options are priced by trading by market participants with a myriad of expectations. Options are NOT priced by using a 'forward' formula that begins with the 'cause' of the move in the underlying and then computing the option price.

In terms of expected moves, option prices are only useful to make an assertion like this: "given that option A trades at price X in the market. this implies that market participants expect that there will be a move in the underlying of Y with probability Z between now and the expiration of the option"

You don't arrive at the option price via a fundamental valuation technique like discounted expected earnings or something similar which you might use to value a stock.

You use the option price to decide simply whether you think the market is over estimating or underestimating the likelyhood of some move in the underlying and making your trade (or not) accordingly.

So if you pair the market's expectation(from the option price) with what you think is likely to come from a specific event in the future you can decide whether or not the options are cheap enough to buy (or expensive enough to sell short) given what you think is likely to occur.

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calculating the move and its likelyhood, from the option price is not difficult, but that should probably be a separate question. –  glyphard Dec 30 '11 at 4:07
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This is not a direct answer, but an interesting way to understand what the options market thinks about an upcoming event is look at near-expiration ATM straddles (long call and long put in same underlying, same strike, same expiration). Being long a straddle is being long volatility in the underlying.

Say it's Wednesday before options expiration and earnings come out tomorrow, Thursday. If you pay 5.00 for the straddle, then the stock has to move up or down 5.00 for the position to make money. If the stock is trading at 50.00, then a 5.00 move on a 50.00 stock gives you an estimate of what the options market thinks the stock will move.

I haven't seen a study or paper on this but given time and data, I'm sure one could argue there is some level of edge here.

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I think you may have an inconsistency in your use of the word expected. In your example paragraph, the price movement is something you expect (that is, you expect a 10% drop). But the market has its own notion of what will happen to price with, say, a drop in reported earnings.

(J.M. Keynes likened the stock market to a beauty contest in a newspaper in which the winner did not choose the most attractive woman, but rather, the most attractive woman that others chose. The winnder, by necessity, will figure out whom others are going to choose, not necessarily the one whom he thinks is the most beautiful.)

Now let's put your question in the context of the beauty contest. Is the price going to go down 10% because of weaker earnings? Or will it go up 2% because the sellers have already discounted the news? Or will it go up 5% because the company's competitors are positioned even worse?

One of the few truly expected moves is when the stock price drops because it is going ex-dividend. (If the board of directors announces a 25 cent dividend, then the stock price will drop by 25 cents on the day that it trades without the dividend.) This is a well known phenomenon that is priced into all option-pricing models. Those who own deep in-the-money calls will exercise those calls before the stock goes ex-dividend, in order to capture the dividend.

Calls will go up in price if there an expected increase in price, reflecting the increased volatility of the underlying price. Corresponding puts will also go up in price as arbitrageurs soak up the free money.

Incidentally, if I were you, I would not buy lots of options because I think the options are under priced. You may be taking what is called in poker a sucker's bet.

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What you say is not correct if I understand you correctly. Correct me if I'm wrong but your stating that before an event the price of both the call and put option increases in price and thus you cant profit from your expectation.

In the case you think a stock will go down 10% you can buy a put and profit from the increase of the price of the option when it drops 10%, now your saying the price of options is very high before this event and it drops after the event. So if the price of all options is expensive, what you could do is sell a call option before this event.

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