# Options Trading: Valuation and basic questions?

? Hello! 1. Am I correct in saying that? Nicos determinants of the strategy to use is the expected trend and volatility of the underlying? 2. Adem? S Black Scholes, Is there any other option? N was evaluated in models? N used? “C” m used in the pr? Actually work? Thanks

The second part is easy.

Cox, Ross and Rubinstein came up with the binomial pricing model. See the link for a brief discussion.

Their book is the second link. It may be old, but it’s still good.

There are a lot of options books on the market.

I’m not sure exactly what you mean by the first part, but those are good things to consider.

There are other things to consider, however.

What are you trying to do? Speculate, protect a position, earn income, create a synthetic security or derivative, etc. There are many things that affect the choice of a strategy beyond trend and volatility. Trend and volatility might be considerations in pricing an option more than strategies or tactics..

1. The key factor in options valuation is the expected volatility of the underlying. That’s because the other determinants that go into pricing an option (strike price, time, interest rate) are known. You have to make your own guess what you think the future volatility will be and compare it with the implied volatility that the option is currently trading at.

Implied volatility is the volatility reflected in the curent option price and represents what everyone in the market in aggregate thinks volatility will be. Think of it as similar to a point spread or over/under line in sports betting. If you think that the implied volatility is higher or lower than your estimate of future volatility, you trade accordingly.

The expected price trend of the underlying isn’t really a factor in options valuation. You value an option in terms of how much you think the underlying will fluctuate rather than which way. You may have a strong opinion on the direction of something but an option is simply a leveraged way to bet on your opinion and its value is the price of that leverage, rather like interest would be the price of leverage if you were to borrow money and buy on margin.

(Note: a slight exception is the concept of skew in option pricing for out of the money options, but I don’t want to confuse you.)

2. There are a number of option pricing models out there, including Black-Scholes-Merton, Cox-Rubenstein, Gastineau, Garman-Kohlhagen, etc… Many models are also adjusted for specific types of options and specific types of underlying assets.

It’s important to understand that if you are trading options, you can’t just take a model, plug numbers into a spreadsheet and use it by rote. You have to be familiar with options theory and understand how models are built and their limitations so you are aware of the opportunities and risks. IOW, you have to think.

Black Scholes uses a Gaussian Normal distribution to predict the future prices of the stock on the basis of the efficient market hypothesis saying that all factors have been priced in leaving only a random walk. Since then there have been several variations each with a modified probability distribution.

It amazes me that people who will fervently argue that you cannot use a random walk to predict stock prices will also place blind confidence in the Black Scholes model and often saying obscure things like you’ve got to learn the greeks when the fundamental component of Black Scholes is the random walk to predict the pricing of the underlying security.

With random walks, you are characterizing the probability distribution with variance and drift corresponding with volatility and general trend. I believe that Black Scholes did not include a drift factor as the EMH states that has already been priced in.

Random Walks are also known as Brownian Motion because Einstein rediscovered the equations independently when studying Brownian motion. Somewhat odd when you consider Einstein’s objections to Quantum Mechanics use of probability distribution functions.

Thorp has said in interviews that he’s found Brownian Motion very useful to model all sorts of securities.