Published March 1st, 2008
in Finance.
Unless you have been in a different planet, you know that the Dollar has declined in value against all major currencies in the world, even against the Israeli currency known as NIS (New Israeli Shekel). In January alone, the Dollar has declined about 7% in value against the Shekel. What followed after such a dramatic was the constant whining of money managers of how speculators have taken over the Israeli market and are doing as they wish. I would dare to speculate that the whiners have been on the loser side and have not hedged themselves against the rally down. It is always easier to blame some unknown cause at your loses than to admit that the only reason you did not hedge against such a decline was because you thought “Hey, it is so low now it certainly can’t get any lower!!”
Having examined the volume traded in the option market on the dollar/shekel, it was evident that the volume has more than doubled. What was more interesting is that more out of the money calls were been bought than out of the money puts. The distribution in normal times is usually 70% for out of the money calls and 30% for out of the money puts. In January it was about 85/15. One of the reasons in my opinion to such a result is due to the fact the as the Dollar started to decline, money managers (such as those who blame speculators) started buying out of the money calls thinking the Dollar would surely soon rally up. This has not happened though.
Conclusions
What can we conclude from this? Firstly, we can conclude that most experts don’t know what they are doing that’s for sure. The 7% fall in one month was not expected. A better way to react was to be more adaptive and not assume because you have not seen such low levels of the Dollar in 10 years that it can’t be happening and it should rise in value! That argument never works.
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Published February 17th, 2008
in Option Trading.
I stumbled upon Peter Carr’s site and saw a very nice explanation on the arbitrage principles that govern option pricing. Usually explanations on option pricing are very cumbersome and not clear. Here is my take on it, but you can just go to his website and find it in the research papers under FAQ.
Suppose you have a stock that is priced at 1$ and it has a 50% on either going up to 2$ or going down to 0.5$. Thus, we assume there are only two states with equal probablity. Let us now assume there is a Call option written on that stock with strike price of 1$. Thus, in the up state it makes 1$ and in the down state it makes 0. Now comes the million dollar question.. how much is the option worth? If you take the expected value approach, you’d say it should be worth 0.5$ since that is the expected profit (
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There are a few problems with the expected value approach. We could also say that the stock should be worth 1.25$ in the future by the same expected value approach. This adds more confusion to the proper way to price the option.
Let us assume that we go with the first approach and we price it to be worth 0.5$. In that situation we could sell two call options and buy one stock. We have no initial cost. If the stock goes up, we make nothing, but if the stock goes down, we profit 0.5$ since the options expire worthless. That is in essence an arbitrage, since we have no risk at all and we stand to gain a profit (although in only one state of the world). This tells us that something is wrong with this approach. The question is, is their a proper way of doing this?
Let us assume that there is no interest in this world of ours for simplicity. This means that as time passes, we demand no compensation for our money if we take no risk. We know that the option pays 1$ in the upstate, and nothing in the downstate. We can construct a portfolio that replicates the option buy noticing that buying 2/3 of the stock and selling short 1/3 of a bond with face value of 1$ with exactly replicate the option price (do it yourself to make sure). The total cost would be 1/3$. What is that magical 1/3$ number we got? I claim that is should be the fair price of an option!
As a good exercise, you should try to figure out why this should be the fair price. But do not worry. In the next post, I’ll explain more about why this should be the fair price and touch upon what is known as state prices.
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Published January 26th, 2008
in Option Trading.
Hey everybody!
I haven’t been updating this blog for about 2 months I think due to personal issues I had. I was also unable to answer any emails you had. But I am currently back in business!
I am currently testing to see whether there is any merit in using the implied risk neutral distribution as a good predictor to future prices in the Israeli Stock Market.
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