Relative Strength
Studies have shown that high relative strength tends to persist. That is to say, stocks that have performed well in the last few quarters tend to continue to perform well.
However, the Black-Scholes option pricing model takes a neutral view of a stock’s future. It treats high relative strength stocks and low relative strength stocks the same way, measuring the value of options on these stocks using only each stock’s volatility.
You should not be overly impressed by the complexity of the calculations needed to produce the Black-Scholes value, or by the reasoning that leads to those calculations, because that reasoning and those calculations are based upon a “know-nothing” assumption. If you know that a stock’s price is going to increase, you know more than the Black-Scholes model and your knowledge tells you more about the value of the options on the stock than the Black-Scholes model.
In particular, your common sense tells you that call options on the stock are worth more than in a “neutral” scenario, and put options are worth less. And your common sense is right.
Next week I will begin publishing the best options of each kind, call and put, to exploit the most extreme relative strength stocks in the Pisani 250. For the ten highest relative strength stocks, the new section of the site will show the five calls which are most underpriced (or least overpriced) and thus candidates for purchase, and the five puts that are most overpriced (or least underpriced) and thus candidates for sale; for the ten lowest relative strength stocks, the new section will show the five puts that are most underpriced (or least overpriced) and thus candidates for purchase, and the five calls that are most overpriced (or least underpriced) and thus candidates for sale.
The theoretical value of these options is useful in the relative strength analysis only in that the theoretical value tells you the least (in the case of purchases) or the most (in the case of sales) that the option is worth. That is, if a call on a high relative strength stock has a theoretical value of $4.00 and you are confident the stock’s price will continue to increase, you can be certain the call’s actual value is greater than $4.00. Similarly, if the theoretical value of a put is $3.00, you can be certain that the put’s value is less than $3.00.
So if the call can be purchased for only $4.00 and the put sold for as much as $3.00, to Black and Scholes this purchase and this sale have no “edge”– but to you they do. To Black and Scholes, the options are worth $4.00 and $3.00. But if you know better, you should use that knowledge.