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Options University’s Options 101 - Part 24

Filed Under Options 101 

Options 101
Part 24
 
Price is the Equalizer
The market places a lower price on riskier assets as a way to equalize the demand. In the pricing game, you placed a higher price on the coin game than the card game. This doesn’t mean that the coin game is necessarily the better game. If the coin game and card game were priced the same, then we could say for sure that the coin game is better. After all, it wouldn’t make sense to pay the same price to play the card game. But because there is more risk with the card game, you will bid a lower amount. Once the prices are established for all three games, then all games are theoretically equally attractive. Your decision on which one to play just depends on how much risk you wish to take (or on how much reward you’re looking for). If you don’t like the $51 payoff of the coin game, you can certainly jump to the riskier card game and go for the $99 reward. Just understand that this decision means you are taking more risk and therefore have a higher chance of losing your investment. The important point to understand is that you cannot jump to a better payoff and take less risk. If you want more reward, you must be willing to take more risk.
Now let’s go back and look at some of the eBay option quotes from Table 1-1, which have been reprinted below in Table 2-8:
Table 2-8
Call Options
Strike
July
August
$32.50
$4.90
$5.50
$35
$2.70
$3.60
$37.50
$1.05
$2.10
$40
$0.35
$1.10
 
 
As we pointed out before, the price of the call options gets cheaper as we move to higher strikes. Notice that this is the same progression as with our pricing game when we move from the guaranteed game to the card game. The price gets cheaper as you move in that direction. This can only mean one thing for the options. They must be getting riskier as we move to higher strikes. However, most traders look at the quotes in Table 2-8 and think that all options could theoretically make an unlimited amount of money since they are all tied to the same underlying stock. It only makes sense to buy the cheapest one, which is the $40 strike. And this is usually a fatal mistake for options traders. Traders who use this line of reasoning assume that the risks are all the same. We now know that cannot be true since the prices are not the same. The market is bidding down the prices of the higher strikes due to the higher risk.
 
Our first pricing principle stated that lower strike calls must be more expensive. We said that a statistical reason for this is that lower strike calls are able to “catch” more intrinsic value and therefore must be more desirable. Lower strikes are more desirable because they are less risky. If it is less risky, it must cost more money.
 
We can show this effect by considering the breakeven points for a call option. If you buy the $32.50 strike for $4.90, the stock would have to close at $32.50 + $4.90 = $37.40 in order to break even at expiration. Because CYBX is currently $37.11, you’re only 29 cents away from your breakeven point. However, if you elect to buy the cheapest option, the $40 strike, then the stock must climb to $40 + $0.35 = $40.35 just to break even at expiration. With the stock at $37.11, that means the first $40.35 – 37.11 = $3.24 worth of movement doesn’t even count for you at expiration! The stock must climb higher than $3.24 by expiration before you make money. There is a very big difference between the $32.50 strike and the $40 strike – and that difference is the risk.
 
Using Table 2-8, many new traders still believe that the $32.50 call must be riskier than the $40 call since there is more money to potentially lose. If eBay falls from its current price of $37.11 to $32.50 at expiration, the $32.50 call buyer loses $4.90 while the $40 call buyer loses only 35 cents. However, if eBay falls to $32.50 at expiration then the stock has lost $4.61 worth of value. This means that the first $4.61 worth of loss on the $32.50 call is a risk that is common to both the stock and the option. It is not a risk that is unique to the option, so it should not be counted as a risk in the option. It is only the value above $4.61 – the 29 cents worth of time value – that is a risk of the $32.50 call. The $40 call loses only 35 cents but it does so if the stock falls, stays still, or even rises to $40 at expiration. It is far riskier than the $32.50 call.
 
Many traders feel uneasy about putting much money into the trade when there are other strikes available for much less money. The key to trading options is to strike a balance between the two. We don’t suggest buying options so far in the money that it costs a fortune but, at the same time, we stay away from buying at-the-money and out-of-the-money options unless we are buying them with a lot of time remaining – perhaps more than a year to expiration. For the most part, you’ll be better off buying options with intrinsic value.
 
Now let’s look at the July and August calls in Table 2-8 above. Why do you suppose the July $32.50 is cheaper than the August $32.50? You should now understand that it is cheaper because it is riskier. As we stated before, the August call gives you more time for the stock to move higher – to build intrinsic value – and that means there is a better chance to make money. In other words, there is less risk with that option, and that’s why its price is higher. Many option traders make the mistake of buying the shortest-term, cheapest option available thinking they are reducing their risk; this is usually why most people lose with options. The short-term, high strikes should be treated like lottery tickets, not investments. Our basic risk-reward relationship can be found in many other areas outside of the financial markets too. As long as there is a price paid in exchange for a possible financial reward, the risk-reward relationship holds. Let’s look at an example outside of the financial markets.
 
Lotteries
Why do you suppose that you can pay one dollar for a state lottery ticket for the chance to make $7 million or more? The reason is that the chance of making that huge reward is very small and so the price will also be low. It does not mean that it must be a great investment because of the “great risk-reward ratio” that so many traders talk about. If there is a great reward, there is a low price – and also a lot of risk.
 
As another example, Figure 2-9 shows two versions of the Florida lottery scratch-off Monopoly game: Instant Monopoly and Super Monopoly.
 
Figure 2-9: Florida Lottery’s Instant Monopoly and Sly
 
 
 insert fig24-1, insert fig 24-2
 
 
 
Instant Monopoly costs $1 and offers a $5,000 grand prize while Super Monopoly costs $5 and offers a whopping $100,000 grand prize. Instant Monopoly offers $5,000 of reward per dollar at risk while the Super version has $20,000 of reward per dollar of risk. As so many players ask, “Why should I risk $1 to make $5,000 when I can risk $5 to make $100,000?”
 
Is Super Monopoly the better game since it has a “better” risk reward ratio? Not necessarily. In order to answer that, we need to know the probabilities of winning each game. Depending on the probabilities, it may turn out that one is better than the other. However, the point is that you cannot just look at the “risk-reward ratios” and make that determination. What we do know for sure is that the Super Monopoly game must be more difficult to win. The higher payout is a reflection of the higher risk involved in that game. In fact, you can verify this by going to the website www.FloridaLottery.com and looking at the odds. For Super Monopoly, the odds are 1:2,520,000 and are 1:890,000 for Instant Monopoly. Although you are not likely to win either game, there is no doubt that, on a relative scale, you are more likely to win Instant Monopoly; that’s why the payout is lower. However, now that we know the odds, we can make comparisons. In this case, Super Monopoly offers four times the reward but is not four times as difficult to win. On a risk-adjusted basis then, Super Monopoly turns out to be the better game to play. However, in the financial markets, this favorable risk-reward ratio would never exist as arbitrageurs would buy Super Monopoly and simultaneously sell Instant Monopoly until the prices were exactly in line with the risk. Because these games are not subjected to buyers and sellers, it is possible (as we see in this example) to find games that are more favorable than others. Despite the unbalanced risk-reward ratios offered by these two games, one thing is for certain: The creators of these games will not increase your reward without making you assume more risk.
 
To be continued…

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