Open Mind For a Different View & Nothing Else Matters

According to Investopedia:

The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is one of the most important concepts in modern financial theory. This mathematical equation estimates the theoretical value of derivatives and other investment instruments, taking into account the impact of time and other risk factors. Developed in 1973, it is still regarded as one of the best ways for pricing an options contract.

To value options, the Black-Scholes model only requires 5 inputs:

1. The Strike Price of an Options
2. The Current Stock Price
3. The Time to Expiration
4. The Risk-Free Rate
5. Volatility

IMPORTANT:  To value options, there is only ONE input that is not provided free of charge from the open market. When we make a trade, we certainly know the current price of the stock and we choose the options strike. The time until expiry is provided for us and the risk-free rate is provided on every financial website in the world.  

The only input that is not provided is volatility. Options pricing is driven by volatility.  

Market Makers follow Unusual Options Activity so they can see where the “smart money” is trading.  When more weird (unexpected) options activity is found, uncertainty increases – which means volatility also increases.

More volatility in the market = more premium for all options = higher options prices.

Let us go through 3 examples:

$TLT – ISHARES TRUST 20 YR ETF

• Extremely liquid
• Widely Followed
• Times $TLT Closed In Expected Move = 87.5%

The green and red lines show the “expected move” for $TLT every month.  Notice how the bottom of the expected move acts as support and the top green line acts as resistance?  In my opinion, the market is excellent at pricing $TLT.  Not surprisingly, the Fed gives lots of hints as to the direction of Interest Rates.

$LEU – CENTRUS ENERGY CORP

• Small-Cap Uranium Stock
• Not Widely Followed
• Times $LEU Closed In Expected Move = 45.3%

$LEU is probably followed by 1/100th of the folks that watch $TLT.  Stocks that have less liquidity also are burdened with more uncertainty. The Uranium industry is flush with uncertainty because of the escalation with Russia and Ukraine.  Again, notice how the red and green lines act as support and resistance? It correctly represents more uncertainty in the pricing of $LEU than in $TLT.

$VIX – CBOE MARKET VOLATILITY

• Widely Followed Volatility Index
• Extremely Liquid Options
• Times $VIX Closed In Expected Move = 95.83%

This chart is telling. The VIX is widely followed and seems to always stay within its expected move.

The next time Volatility picks up, watch the expected move of the VIX to see when things will calm down.