Financial Chess: You Against The World
When you trade options, you are in a sense betting against the entire world, just as Garry Kasparov did in his recent chess match (see the October 26 commentary). And the “Options World Team,” meaning the options market itself, contains some superb players.
The options game has its own World Team Analysts, just as the world did in the Kasparov match. But these analysts aren’t chosen by MSN, and they may not even know one another. They are professionals. If an option price deviates in a significant way from the option’s value, the professionals who make their living at this game will pounce, buying the option if it is underpriced and selling it if it is overpriced. They will then protect their position by hedging away the risk as much as possible.
| If an option price deviates in a significant way from the option’s value, the professionals who make their living at this game will pounce |
What do we mean by “value?” Certainly the Black-Scholes model gives you one opinion of value, and this opinion may well be correct. But it also can be clearly incorrect in certain cases. For example, suppose you know that a vote has been taken by a company Y to purchase all the stock in company X for a price much higher than today’s price, that the board of X has decided to accept this offer, and that this information is not public. Options on X will not be “correctly” priced by the Black-Scholes model, because this model does not take such information into account. But if you have such information and are looking at the call options on X, which adhere more or less to Black-Scholes values, these options will be quite underpriced in your eyes. To you, their value will be considerably higher than the value perceived by the market, and you will be inclined to buy them.
I am speaking hypothetically, as the U.S. has strict laws against the exploitation of such inside information. But the fact remains that the value of these options to you is quite different than the value perceived by the market.
In a sense, in such circumstances you would be a chess master among novices. Assuming you are an extremely well-heeled fund, your purchasing power may well push the X-option prices to a level where they are still undervalued to you but appear overvalued to the market, which generally looks at Black-Scholes values. These high option premiums may entice traders to sell them. In effect, the market would be selling the spuriously overpriced options to you, to whom they are clearly under-priced.
More likely, you will not be in the position of the fund, but rather in the position of one of the novices. If you write this option, even at its inflated level, and do not implement an adequate hedge for your short position, you may be asking for trouble.