Suggested Reading: Options Pricing

[specialkayme]

In part for my own personal development, and in part for my own entertainment, I'd like to understand more of and devote a small (5% or so) portion of my investments to long term LEAP options on some fairly conservative investments.

I've read a few books on options already (including an introductory Understanding Options - https://www.amazon.com/Understanding-Options-2E-Michael-Sincere/dp/0071817840/ref=sr_1_1?ie=UTF8&qid=1516715805&sr=8-1&keywords=stock+options and a more thorough and a more thorough Options as a Strategic Investment https://www.amazon.com/Options-as-Strategic-Investment-Fifth/dp/0735204659/ref=sr_1_8?ie=UTF8&qid=1516715805&sr=8-8&keywords=stock+options), but the use of the "greeks" in selecting the right option, and general pricing concepts, still get me a little lost. I've browsed around, and many books on the topic appear to be rather pricey (and not at my local library) and somewhat intellectually dense. I'll request my local library purchase a copy of a good book if I can, but I don't want to "blow" my chances on a book that I don't get much out of.

Any suggestions on some good reading to better understand options pricing and the "greeks"?

[yachi]

I just read up a little online and started buying calls.  LEAPS have been very lucrative for me.  I've been buying them since 2012 or 2014, but only on Berkshire Hathaway stock.  I look at pricing two ways:
1.  (Strike+Ask-Current Price)/Current Price.  Convert this to a yearly interest rate.  Would you borrow at this interest rate?
2.  Calculate the intrinsic value of the stock, and projected growth over 2 years.  How much do you stand to gain? For Berkshire Stock, the company offered to repurchase at 1.2x book value.  Calculate 1.2x book value and conservative growth over 2 years.  You can consider this as somewhat of a floor.  Can you live with this loss?

I buy mostly in-the-money calls because they have the best balance of potential gain and potential loss.  I currently have $170 and $175 January 2020 calls when the stock is trading at 215.  I sold some of these when I got nervous due to how quickly they appreciated.

The other thing I would suggest is consider doing your buying in an IRA account.  You can't have margin in an IRA, but you can buy LEAP calls.  You can buy and sell in an IRA without having to consider the tax implications, or if they are long term or short term gains.

[specialkayme]

Do you not consider the greeks at all when doing your analysis?

For example: with Berkshire Hathaway's (BRK/B) options:

Strike Price:     160          170          175
Delta:              0.83         0.80         0.78
Vega:              0.77         0.85         0.89
Implied Vol:     31.24%    28.61%     28.10%

Those are just three examples, but do you compare the difference in these when deciding between options, or instead just run your (Strike+Ask-Current Price)/Current Price for each three and compare them to each other, ignoring the other factors?

[yachi]

I ignore them for the most part.  When I started I read up on the Black-Scholes option pricing, which includes volatility of the underlying stock in its calculation.  It doesn't seem to me that an option should be priced higher just because the underlying stock is moving up and down more frequently than another. 
I basically use options to gain leverage for stocks I think are undervalued, so it makes sense to pay attention to the 'borrowing cost' by figuring out an equivalent interest.

[specialkayme]

Interesting.

So I ran the calculations, for my own understanding, on the BRK/B longest LEAP options, of
((Option Strike + Option Ask) - Stock Price) / Stock Price

With a Stock Price = 215.2456, and converting the results into percentage form, I got:

Strike Price      %
150                 6.85%
155                 7.05%
160                 7.66%
165                 7.96%
170                 8.30%
175                 8.8%
180                 9.5%
185                 10.2%
190                 10.7%
195                 11.3%
200                 11.8%
210                 14.0%
220                 15.4%
230                 17.8%

So it's appearing to me the more ITM you go, the lower your "interest rate." So what caused you to stop at 170 and 175? Was it the highest "interest rate" you felt comfortable "lending at"?

[yachi]

If you're looking to borrow more, or looking to use options instead of margin accounts it does make the most sense to choose the deepest in-the-money calls available.  In my trading so far, I have always had a value for the underlying stock in mind when buying calls.  Here's what my spreadsheet looked like one the last time I updated it.  The $170 calls I bought for $33 in November.  I've sold about 2/3 of them because of their run-up.  I expect the level at which the company will repurchase stocks to increase to $189 by November 2019 (in time to sell 2020 calls back).  I expect the stock to reach is intrinsic value of $234.34 by November 2019 as well.  The balance of potential gains and potential losses the last time I loaded the data was not very attractive to me.  When I bought the 170 and 175 calls, they had the possibility of a high gain, wit the protection of a 10% or so loss.  The higher strike price options would have gained more, but at the risk of higher potential losses.

[thunderball]

Definitely look at Delta and Probability In/Out of the Money.  Delta is a quick shorthand for the percentage an option will move vs. the underlying equity.  For example, the JAN 2020 170 Call with 719 Days to Expiration has a delta of .81, so its price will move roughly 81% of BRK/B.  Higher deltas are more expensive, but you're paying for Intrinsic Value.  Lower deltas are cheaper, being Out Of the Money (OOM) you are paying only for time / Extrinsic Value.

You can see exactly how the market prices the option by looking at the Probability OOM:  the 170 call has a 31.11% chance of being below 170 at expiration.  The attached pic is from my Thinkorswim account, and you can get an account for free.

If you want to learn more about options, check out https://www.tastytrade.com/tt/learn.  Great tutorials!

[sokoloff]

I ignore them for the most part.  When I started I read up on the Black-Scholes option pricing, which includes volatility of the underlying stock in its calculation.  It doesn't seem to me that an option should be priced higher just because the underlying stock is moving up and down more frequently than another.

Do you think that an option to buy (or sell) $100K of Amazon or Tesla should not be higher priced than an option to buy (or sell) $100K worth of Walmart or Proctor & Gamble?

Intuitively to me, the more volatile an underlying stock price is, the more valuable the option (a right, but not an obligation, to force a counterparty to do something) is.

[specialkayme]

I expect the level at which the company will repurchase stocks to increase to $189 by November 2019 (in time to sell 2020 calls back).  I expect the stock to reach is intrinsic value of $234.34 by November 2019 as well.

How did you come to those numbers of stock price after repurchase and intrinsic value?

I appreciate you taking the time to explain.

If you want to learn more about options, check out https://www.tastytrade.com/tt/learn.  Great tutorials!

Thanks for the info, I'll have to check that out.

[yachi]

I ignore them for the most part.  When I started I read up on the Black-Scholes option pricing, which includes volatility of the underlying stock in its calculation.  It doesn't seem to me that an option should be priced higher just because the underlying stock is moving up and down more frequently than another.

Do you think that an option to buy (or sell) $100K of Amazon or Tesla should not be higher priced than an option to buy (or sell) $100K worth of Walmart or Proctor & Gamble?

Intuitively to me, the more volatile an underlying stock price is, the more valuable the option (a right, but not an obligation, to force a counterparty to do something) is.

If I know nothing about the underlying company, than I suppose volatility measurements is as good as anything to establish which option should be priced higher.  I don't like to invest in companies I don't know anything about, so I don't do this.  If I know the direction the stock price should move based on the underlying fundamentals of the company (sales, profits, taxes), that option would be more valuable to me. 

[yachi]

I expect the level at which the company will repurchase stocks to increase to $189 by November 2019 (in time to sell 2020 calls back).  I expect the stock to reach is intrinsic value of $234.34 by November 2019 as well.

How did you come to those numbers of stock price after repurchase and intrinsic value?

I appreciate you taking the time to explain.

If you want to learn more about options, check out https://www.tastytrade.com/tt/learn.  Great tutorials!

Thanks for the info, I'll have to check that out.

I used an analysis by Whitney Tilson (google whitney tilson brkb).  I take his estimate of the intrinsic value of the stock (296,000 per A share - 197.33 per B share) in May 2017, and use his growth and cash build numbers (6% annual growth and $6.667 per B share cash build) to adjust out to the last quarter results before the option expires).
For the repurchase value, I start with 1.2x current book value, and adjust it forward using 6% annual growth and $6.667 per B share cash build. 

I'm quite a bit priced out of these options based on this analysis so I'm not adding any additional options.  The above technique seems to work fairly well around November when the new LEAPS come out.

[specialkayme]

Yachi - Thank you for providing that information. I took a quick look at Tilson's May 4, 2017 presentation. A whole lot of information there, and it will take me substantially longer than a glance to fully evaluate it all. But thank you for that lead.

Your system appears to be working very well for you, but I'm not sure I'd be able to implement it as well as, or with as much confidence as you.

It seems to me that most people that trade in options look at it in one of two ways: (1) they attempt to guess the actual stock's value by the expiration of the option, or (2) they aren't able to guess the stock's value by the expiration, but instead attempt to guess the direction the stock will move, and roll the options forward whenever sufficient profit is made.

If you take the first view, it works fairly well if you can have a predefined stock price at a predefined future date. At that point, you can fairly accurately calculate risk, projected return, and narrow it down to the option you think will work best. With tickers every 5 or 10 points, that's somewhat of a narrow target to hit two years out. So the way I view it, that takes some fairly serious projections to be able to hit those targets. Plus, if you're any form of a "random walk" believer, there's no way you can actually predict the price.

If you take the second view, you believe that the stock will move in a certain direction. So you can still be a "random walk" believer, if you believe the market on the whole will increase ~7+% per year. You just believe over the next two years the market will increase, without being able to predict at what price point and at what date. If that's the case, I don't see much discussion on calculations and estimations on profitability between two options. Instead, it's more of a shot in the dark, going further ITM the more risk adverse you are and more OTM the more risk seeking you are. If you're planning on rolling the options forward once you've made sufficient profit (or whenever you've taken so much of a loss), you'll never be holding the option to the expiration so calculation of "time value" within the option seems more like a misnomer. If that's true, the only value difference between a Call that is 30% ITM and 20% ITM (with equal expiration dates) has to do with the investor's psychological value they associate with it, and not much to do with the price of the underlying option itself.

Or am I totally off base here?

[yachi]

I was confident in November that what I was buying would be good for the next 2 years.  When it suddenly went up in December I started worrying about the potential losses and sold most of my calls for 30% gains.  They've increased maybe 30% since then, so maybe I sold too soon.  Putting aside the actual pricing difficulty of options, I have some thoughts on the dangers of LEAPS:

1. There is an expiration to Calls, so:
  a. If you suddenly pass away, your heirs need to know to sell before your expiration or it's all gone.
  b. If the stock market closes for a 2-3 month period during which your options expire it's all gone (It happened during WWI from July 30 to December 12 of 1914).  Some type of electronic attack could cause it again.
2. The leverage is huge and high leverage resulted in the 1929 stock market crash.  Consider the $170 calls with the stock trading at $215.4.  They have a last price of $53.3.  If you look at this as a loan, you're controlling $215.4 of stock for a downpayment of $45.4 [215.4-170] and an interest payment of $7.9 [170+53.3-215.4].  That's a 21% downpayment [45.4/215.4], and a 2.3% yearly interest rate [7.9/(215.4-45.4)/2].  Your ownership of this asset expires after 2 years, but you can generally renew for similar terms.  This is very cheap borrowing, but when I consider the market that allows this to happen I get nervous that the groups behind it will be able to sustain it.

I'm not sure what counterparty has suffered the losses on the other side of my gains on Berkshire calls.  I imagine it's been a series of individuals each losing 5% because if makes me feel better that way.

[sokoloff]

1. There is an expiration to Calls, so:
  a. If you suddenly pass away, your heirs need to know to sell before your expiration or it's all gone.

The options clearing corporation (OCC) will auto-exercise any long option that closes trading in the money by a penny or more. Your options contract is actually cleared by the OCC [when you buy a call from "counterparty B", you are entering into a contract with OCC and OCC is entering into an offsetting contract with counterparty B].

Now, you still may need to be concerned with whether you have sufficient buying power in the brokerage account that will hold the shares to avoid a forced liquidation, but the risk of loss in a is greatly less than what's stated above.