For an investor who understands how to read the option market’s tea leaves, investing becomes like playing poker with an opponent who always holds his hand face up. This might seem too good to be true, but in fact, option prices contain within them the market’s consensus estimates for the future price of a stock. If you know where to look, you can easily decide if the market’s consensus price for a stock is near or far from your own idea of its value. Value investors who revel in finding differences between stock prices and intrinsic values will love what the option market can tell them about future expectations for stocks.
What Option Can Tell an Intelligent Investor?
Option pricing models are, first and foremost, statistical models of how stocks are likely to move in the future. The option pricing bit is almost an afterthought once the hard work of stock price forecasting is done. all option pricing models under the general term “Black-Scholes Model” or “BSM.” All subsequent models are basically tweaks of the BSM, in fact.) For all the mathematical complexity people associate with option pricing, it’s actually a pretty blunt tool. It’s based on a few, almost laughably simple assumptions:
1. The market is “efficient”, so a stock’s market price represents its true value.
2. Stock prices drift upward at the same rate as the rate of return for risk-free bonds.
3. New positive and negative information relevant to the stock’s price comes in randomly, so the stock is as likely to go up as it is to go down.
4. Stock returns follow a bell curve distribution.