EDUCATION INNOVATIONS CATALOGUE

* 1973- Robert Merton relaxed the assumption of no dividends. * 1976- Jonathan Ingerson went one step further and relaxed the assumption of no taxes or transaction costs.

* 1976- Merton removed the restriction of constant interest rates. The results of this evolution are alarmingly accurate valuation models for stock options.

Ok, you think that is boring you should read some of the papers and equations (I have and it was not fun).

Modern option pricing techniques are among the most mathematically complex of all applied areas of finance but they have reached the point where they can calculate, with alarming accuracy. Most of the models and techniques employed today are rooted in the Black and Scholes model. One notable major advance is the Cox, Ross, Rubenstein binomial model widely used in more volatile stocks. In fact the brainiacs currently have 7-9 different models out there trying to out do each other. Here is the basic idea…

Option Pricing Model: A mathematical model is used to calculate the theoretical or fair value of an option. Inputs to option pricing models typically include:

• * the price of the underlying instrument (stock): Fixed.
• * the option strike price: Fixed. * the time remaining till the expiration date: Fixed.
• * the volatility of the stock: Fixed.
• * the risk-free interest rate (e.g., the Treasury Bill interest rate): Fixed.

The historical accuracy of the prediction is quite good but short term variations to the price models can and do "Kill" traders on a regular basis. In the long run the models are cool but they are THEORECTICAL and subject to CHANGE!!!!! The difficulty is that the vast majority of option traders do not have the knowledge or even the viewpoint to see the variation when they come. Nor are they able to reflect anomalies in the price structure when they look at an option chain to get a price.

• This is one of the reasons I so dislike Prescriptive Option Strategies. The prescription dictates how to make the trade. It dictates buy/sell, strike price and which month. Well that's just fine if the market stays constant and the price structure does not move. Ok… so "hey market, I am going to trade now… could you please just stay calm and act really normal and don't do anything rash until I am through? Thanks, that would be real nice of you." Somehow I don't think it works that way. The real problem with most option traders is that they don't know what they don't know.
• For example; today, with the stock at support and moving up it may or may not be a good idea to buy a call option. It may or may not be a good idea to trade the In the Money strike price. It may or may not be a good idea to trade the next month out. The pricing composition will reveal hidden potholes if you can read it. If the prescription can work, great! But if the pricing landscape is significantly off, you may have a prescription for disaster. Ignorance may be bliss but it is expensive.