Imagine trading stocks, futures or options without the assistance of market makers. The result would be many orders unfilled along with large jumps in prices as buyers and sellers try to agree on acceptable market values. Thus, market makers are a vital part of trading, dependably taking risks and committing capital for the benefit of all.
The tools that market makers use to provide liquidity are powerful pricing mechanisms. The rest of us can use them to improve our own options trades or establish profitable spreads between strike prices at the same expiration date. Here, we’ll offer up some analysis that suggests ways to accomplish these objectives.
Market prices for futures and equity options typically are based on variants of the Black/Scholes theoretical pricing model that originated in 1973. These models permitted the growth in computerized option trading that began on the Chicago Board Options Exchange and continues today with massive quantities of electronic trading.
Because of the smooth price surface presented by the current options market, individual traders have relatively little power to influence prices and generally must accept what is given by the theoretical price models in use by financial institutions and the market makers who bridge over gaps related to low trading volume.
However, there is an advantage built into the system that benefits the average options trader. The closely organized pricing of options allows anyone in the market to compute formulas that describe and predict options prices in two ways: First by showing what the option price should be at each strike price given the current underlying asset price, and second by predicting option prices over short time periods given changes in the underlying.
"September crude oil" (below) shows how tightly priced the options for September crude oil are on June 20, 2011. The analytical model is the non-theoretical LLP counterpart of the options market’s theoretical pricing and is available as a free Excel worksheet download here.
Over the span of 16 strike prices for September crude oil, the largest variation from the predicted price is approximately 0.02% of one option point, or $20 at $1,000 per option point. Only two variations are larger than 1% of the option premium. The chart in "September crude oil" presents the market price and predicted price at each strike price. The close fit between the two series of prices is shown by the regression-predicted price falling on top of the market price at each strike price.
The main advantage of the LLP analysis is that it doesn’t matter what form the institutional theoretical options pricing models take as long as the regression formula can analyze and predict market prices accurately based on current data. Arbitrage in the options market keeps prices at every strike close to a theoretically correct value. However — as shown in the table — there remains a small amount of slack in the system. In the case of September crude oil on June 20, the differences between market and predicted prices extend from plus $14.68 to minus $24.61.