From the September 01, 2011 issue of Futures Magazine • Subscribe!

Trading option break-even prices

Market prices of futures and equity options lie on price curves that are described by log-log parabolas. This means that there is little difference between the market price of an option and the price that is predicted by a regression equation. In addition, each option price is determined by its upper and lower break-even prices — the market’s forecast of the underlying futures or stock price at the option’s expiration date that will produce a zero gain or loss from a current trade that balances the price changes of an option and its underlying asset.

Option prices represent tangent points along the price curve. A line that extends from a point on the horizontal axis (at the upper break-even price) to the intrinsic value line (where the intersection lies directly above the lower break-even price on the horizontal axis) will pass through the tangent point. Thus, an option price curve is shaped by an infinite number of paired upper and lower break-even prices, with each pair generating an option price on the curve.

An option price curve starts with the prices listed by actual market trading, but artificial prices can be added once the regression equation is computed. The large number of strike prices listed and traded for many futures contracts results in option price curves that are smooth, with prices that rarely deviate from the predicted values by more than a few option points.

There is both good news and bad news resulting from such organized and predictable valuation of options. The bad news — that we are dealing with logarithmic calculations — certainly is overcome by the good news of more complete understanding of options and their valuations and the possibility of trading on the knowledge of upper and lower break-even prices.

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