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11:21 am
January 3, 2012
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jalleninvest
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Option prices imply stock prices, what the market expects the stock price to be in the finite future. It has nothing whatsoever to do with value, different than the stock price. The options traders have no more idea of value than anyone else, and everyone else's idea is reflected in the price. Our job is to look for, and discover, situations where stock price deviates from "value" with an appropriate margin of safety.
This is akin to calculating RSI, or some other technical indicator, which might have all sorts of meaning as an indicator of future stock price action, but nothing whatsoever about "value" as we use and understand the term.
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8:05 am
September 12, 2011
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somrh
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Post edited 1:10 am – September 12, 2011 by somrh
First, I never intended this as a metric of "intrinsic value" nor have I stated it as such.
Second, my claim was that the two prices (stock and my calculated price) should be identical. And they are roughly the same (if you look at GLD, for example, you get the market price back within a close range.) The fact that they are sometimes not the same is interesting.
I did offer one possible hypothesis and that was that stock traders and option traders have "collectively arrived at different prices". (I use scare quotes because I think the idea is quite dubious but it's a common way to talk.) But I did so with great reservations. For example, my model makes explicit use of assumptions which are plainly false (though perhaps decent rough approximations.) One explanation that might be offered for the price deviations may rest upon the way in which my assumptions fail to capture actual trading.
The formula may not capture "intrinsic value" in any way but it does describe the relative value of these financial instruments. That I think you would agree with since they are derived from arbitrage situations. Those situations have a very well defined value that is largely independent of the underlying business. For example, consider the conversion trade (I linked in my original post):
You initially buy 100 shares of stock at price S, buy one put contract at price P and sell one call contract at price C. The call and put options are of the same strike price K and the same time until expiration t. Initially you allocate a total sum of capital:
S + P – C
At expiration you will recieve K (either the stock price will be above K in which case, the call option holder will exercise her right to buy at price K or the stock price will below K in which you have the right to sell at price K).
For allocating this capital for time t, you require some return on your investment given by a rate r. The end result is this (assuming a continuous rate of return):
(S + P – C)e^(rt) = K
Since S, P, C, t and K are known quantities you can easily find the rate of return for executing this trade.
The conversion trade as well as the box spread have very well defined intrinsic values. Combining these ideas you can derive an estimate of the relative value between the stock and underlying options. The clear advantage of this is that it's entirely independent of "volatity" that Black Schole's relies on though it is incapble of giving you the value of the call option without knowing the stock and put option prices.
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6:10 am
September 12, 2011
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valueinvestortoday
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I think that your calculation, and doing such calculations, is a good activity to engage in on paper because it causes one to think and that action is the most important fundamental to investing. However, I don't see any validity to your claculation in practice simply because it is not based on the underlying assets and/or future cash flow's of the business. In fact, it is 100% dependent upon what a large group of fallible human beings, whom you've never met, have determined what the fair value of the security is worth. By relying on this type of data to derrive an "intrinsic valuation" you are breaking a couple basic rules that are the backbone to value investing:
"You 're neither right nor wrong because other people agree with you . You're right because your facts are right and your reasoning is right—and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else." – Warren Buffett
AND
"An investment operation is one which, upon thorough analysis, promises
safety of principal and an adequate return. Operations not meeting these
requirements are speculative." – Benjamin Graham
Furthermore, I have found no data that would support the notion that options investors are more or less intelligent nor experience more or less success in their ventures than those that participate in common stocks or any other equity. However, in my personal experience, I have found more cases that someone experienced a permanent loss of capital through the options market than those who engaged in common stocks; but that is only in my experience of having discussions with various people about their investing history.
In any event, that is my opinion of that matter however, you are neither right nor wrong because I disagree with you….:)
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6:22 pm
September 7, 2011
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somrh
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I think that's right. It's sort of a gauge on what option market participants think the stock is worth. My idea (and I'm still debating whether or not one can interpret this formula this way) is that market price and option prices can deviate. In that case, you can ask the question, why are they deviating?
The only way I could see it being useful is if you think that option players (on average) are more sophisticated investors as compared to stock players (on average), then price deviation might be an indication of value as compared to market price.
The problem, I think, is that there can be a lot of uncertainty in this equations (due to wide bid/ask spreads in some cases) and given my assumptions, it might not actually be useful for that purpose. Granted, there is a lot of uncertainty in any valuation technique and the economic/financial world (as far as I can tell) don't use uncertainty calculations (I have a write-up I'm working on in this respect. The interesting thing is that I can offer theoretical proof, under certain conditions, that "growth mutilples" is a risk factor.)
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5:35 pm
September 7, 2011
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Jae Jun
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ok im going to be honest and say that I have no idea what this means because options is just outa my league.
But I have one question, unless it's a stupid one, feel free to ignore it.
Since you are looking at the option prices which are based upon market values as well as people's perception, isn't this method just a general consensus of the public or a complicated method of PE?
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2:59 pm
September 5, 2011
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somrh
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Post edited 8:31 am – September 5, 2011 by somrh
Example: BRK-B with Stock Price of $69.37
We'll look at strike prices of $60 and $70 for the Sept '11 expiration and the Jan '13 expiration.We'll use numbers from the Bid/Ask spreads listed on yahoo finance. The last trade price is not always useful as many options are not terribly liquid and the last trade may not fit the current Bid/Ask prices.
Sept '11 Bid/Ask Spreads
$60 Call – $9.40/$975
$70 Call – $1.31/$1.37
$60 Put – $0.16/$0.21
$70 Put – $2.04/$2.11
There are a couple of ways to do this. The first is to average the Bid/Ask Spread numbers to get an average stock price. Doing so gives a stock price for BRK-B at $70.14 which is a 1.1% premium to the current market price.
In a more realistic scenario, to do the options trade it would be required to take the Bid (in the case of selling) or Ask (in the case of buying) price as given. Using these assumptions we can get upper and lower bounds on the price.
The results give a range between $68.35 (-1.5%) and $71.93 (+3.7%)
Next we'll look at Jan '13 Bid/Ask Spreads
$60 Call – $16.00/$16.30
$70 Call – $9.80/$10.80
$60 Put – $5.85/$6.25
$70 Put – $9.45/$10.00
This gives a range of $60.15 (-13.3%) and $74.35 (+7.18%) with an average of $67.25 (-3.1%).
I'm still not sure how these results should be interpreted. I think it will probably vary on a case by case basis. For example, with HRBN we find a relatively high short interest so the people trading the stock are mostly longs and shorts may be required to using options strategies to trade the stock. This would result in an inflated stock price compared to the calculated stock price given by option pricing.
Looking at $16 and $17 strike prices for Mar '12 for HRBN we get an average stock price of $14.60 which is -16.3% from its current price of $17.44. The range for HRBN is also interesting varying between $-10.80 and $40. This variation in the range is due to high bid/ask spreads.
In addition, some of the results should be interpreted in light of deficiencies in the assumptions of my model. For example, transaction costs will have an effect, conversion and box spread trades may not have identical risk profiles, the possibility of early exercise may also have an effect, etc.
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1:21 pm
September 5, 2011
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somrh
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I don't know if there will be much interest in this since this is a valuation technique that depends upon the value of call and put options of a given expiration. But it might be insightful to see if options traders are getting the same value for the stock as the current market price. I'm guessing this is probably a well-known result amongst option traders but I haven't found it (I haven't really looked either) and I derived it independently.
I have some reservations in how to interpret this. For one, it depends upon option prices which may have a wide bid-ask spread. So there is a decent amount of uncertainty in the calculation. Secondly, I made a number of assumptions in order to derive the equation. For example, I assume that the underlying stock pays no dividend, that there are no transaction fees, that the trading risk is the same for a conversion and a box spread, that the options are European and probably some others that I'm forgetting to mention offhand. Most of these assumptions are false but they may be decent approximations nonetheless.
What makes this different is this model depends upon two arbitrage strategies in options trading which I've already mentioned: Conversion and Box Spread. Since arbitrage strategies are seen as good opportunities by many value investors, there may be some sympathy for this method. So with all of those reservations, here is the formula:
Suppose that for a given expiration time, we select two strike prices J and K. We denote the price of the call option for strike price J as C(J) and the price of the put option for strike price K as P(K). Then the stock price S is given by:
S = [J ( C(K) - P(K) ) - K ( C(J) - P(J))] / [J-K]
I've tested this out on a few different assets and I've gotten interesting results. In some cases, the calculated stock price is about the same as the market stock price as was the case with AAPL. In the case of ARO, I found the calculated price was higher than the current market price. In a trial of HRBN (which has both an offer for buyout from the CEO and accusations of fraud by short seller) I found a much lower calculated price than the market price. I'm still unsure of how to intperpret this.
I should also note that you can sometimes get different results by choosing different strike prices and different expiration dates.
If there is interest in the derivation I can write up something and hopefully some of you can check my math and make sure I'm explicit about all of my assumptions.
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