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Oct

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Understanding the Difference Between Price and Value When Trading Stock Options

Filed Under Beginner Options Trading 

Price and Value
In order to understand the difference between price and value, let’s take a look at a real-world example. In Figure 6-8, you’ll see an eBay auction for one million Iraqi dinars:
 
Figure 6-8
 Figure 6-8
At the time of this auction, there were many similar auctions for this currency because of the radical changes taking place in Iraq. The country was getting lots of U.S. support to help its new government get under way. They also have the second-largest oil reserves in the world, so there is tremendous potential for their currency to rise against the dollar. If you buy a large block of its currency, you’d only need a small movement in the currency against the dollar and you could make a lot of money; at least, that’s the investment story the sellers of Iraqi currency are touting on eBay. Figure 6-8 shows this opportunity could have been yours for the low, low price of only $990.
 
We know the price is $990 but that really tells us nothing. Any asset can be priced too high no matter how good the story is that comes with it. The rarest works of art and most precious gems can be a horrible investment if too much is paid for them. As investors, we cannot just look at the $990 price tag on this eBay auction and think it is a good deal because of a good story. We need to somehow compare the price to the value.
 
That’s easy to figure out since there is an open market for currency. All we need to do is look at the exchange rate for Iraqi dinars and convert them to U.S. dollars. At the time of this auction (May 27, 2005), the exchange rate for U.S. dollars per Iraqi dinar was .00068, which means that one million Iraqi dinars were worth 1,000,000 * .00068 = $680. Now we have a benchmark for value since we know what the crowd is willing to pay. However, this auction dealer wants $990 for something that is worth $680 in the open market. Not only is this not a good deal but there’s a more insidious side to the trade than just being overpriced. If you pay $990 for the block of money and its value rises, you could still lose. For example, if the block of money rises from $680 to $900, it certainly went up substantially in value but you still lost money since you paid $990. This is exactly what happened with our AGIX $20 call. The price of the underlying stock rose, but our option was overpriced. The moral of the story is that if the price you pay is greater than the value, you can end up with a loss even if your directional outlook is correct. The legendary investor Warren Buffett said it beautifully: “Price is what you pay. Value is what you get.” 
 
The price of an option is in no way related to its value.
 
 
Option Prices and Point Spreads
One of the best ways to understand option trading is to realize they can be viewed as a directional bet on the underlying stock. (This is not to say we are using options to bet on stocks. Instead, it’s a framework to help us understand what went wrong with the AGIX $20 call.) As with any bet, you put up some money in hopes of making a particular reward. There is some probability of winning along with a probability of losing. The amount you’re willing to wager on a bet can be thought of as the price of the bet. But, as we will show shortly, some prices reflect a good deal while others do not.
 
In order to better understand how some prices can be too high, imagine that it is 2004 and you are betting on the Super Bowl between the New England Patriots and Philadelphia Eagles. You do your homework and find that all of the analysts are predicting that New England will win. To the unwary, it sounds like betting is too easy; all you have to do is bet big on New England and you’ll make money. Unfortunately, you find that everybody wants to bet on New England and you cannot find anybody to take the other side of the bet. How can you entice someone to take the other side? There are several ways but one of the easiest is to offer a point spread. While nobody may be willing to bet on the Eagles in actual points (or “even up”), people will take the bet if you create a point spread. For instance, if you offer a seven-point spread on New England then anybody betting on that team must subtract seven points from the Patriots’ score before comparing it to the Eagles’ score in order to determine who wins the bet. If the Patriots win 21-14, there is exactly a seven-point spread and no money is won or lost. A bigger spread results in a win for the person betting on the Patriots while a smaller spread results in a win for the one betting on the Eagles.
 
If nobody accepts the bet with a seven-point spread, you can always increase it until you find a “buyer.” At some point, people will think the bet is fair and take the other side. Figure 6-9 shows the spreads at the Stardust and Mirage Casinos and you can see they were offering a seven-point spread, which is designated by the -7 under each of their names:
 
Figure 6-9
 Figure 6-9
 
The spread acts as a way to even up the bet. It’s the way in which markets are created; otherwise everybody would bet on the favored team and there would be nobody left to take the other side of the bet. The spread is increased until we find an equal number of buyers and sellers. If the spread is too big, bettors will realize that they are better off betting against their team even though they think they will win. It’s only when the spread is just right that we end up with an equal amount of buyers and sellers on either side of the bet.
 
Figure 6-9 shows the final score was 24-21 in favor of New England. This means anybody who predicted New England would win betted correctly, but they still lost the bet. In other words, New England won but not by a big enough margin to win the bet.
 
Now let’s see how this football analogy relates to the options market. At the time the AGIX quotes were taken there were numerous articles about upcoming experiments for one of its drugs to reduce the amount of fatty plaque that causes clogged arteries. If the experiment is positive, the stock’s price could jump significantly.
 
Now think about this. If everybody believes that AGIX will rise, then everybody would want to buy call options (just as if everybody thinks the Patriots will win then everybody wants to bet on them). And if everybody wants to buy calls then there is a problem. Who is going to sell those calls? The answer is that nobody will. That is, nobody will sell them unless you offer a point spread on the “bet.” And that’s exactly what has happened with the AGIX $20 call.
 
Figure 6-6 showed that the $20 call was asking $4.80. In essence, anybody buying this call is really betting that the stock’s price will be above $20 + $4.80 = $24.80 by expiration since that’s the breakeven point on the option. The $4.80 time premium of the option acts in the same way a point-spread does for a football bet. It’s only because of this $4.80 “point-spread” that a market between buyers and sellers could be created. If the time premium was higher than $4.80, then the point spread would be too big and we’d have too many people wanting to sell the bet and the price would fall. If the premium is less than $4.80, then the point-spread is too small and traders would believe the $20 call is a good deal. We’ll end up with too many people wanting to buy the call and the price will rise. A price of exactly $4.80 is what is required to balance the number of buyers and sellers at that point in time.
 
Notice that, at expiration, if the stock rises from $18.81 to $24.80 or less, any trader who paid $4.80 for the $20 call loses the bet – even though the stock’s price rose. This is exactly what happened to those who bet on the Patriots with a seven-point spread. Even though they were betting on the correct team, they still lost the bet since they did not win by a big enough spread. And this is exactly what happened to the traders who bought the $20 call on September 16 and tried to sell it six days later. Although traders buying the call were correct on the direction, they accepted too big of a point-spread on the bet. In short, the price of the call was much higher than the value.
 
 
To be continued…..

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