# How close are ASX ETOs priced to theoretical value?



## markrmau (14 February 2011)

Hi,

Just wondering if there are any studies on how closely priced ETOs (or warrants) are to Black–Scholes theoretical values?

I am principally interested in ASX.

If no formal studies, what about anecdotal evidence from traders?

Thanks,
Mark.

(PS - Long time, no speak.  Hope everyone managed to get through the GFC without too much heartache)


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## wayneL (14 February 2011)

What is the theoretical value?

The only unknown input is volatility, so theoretical value must include some theoretical volatility. 

The only measurable theoretical volatility is historical AKA statistical volatility... with all the caveats that entails.

PS good to hear from you.


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## markrmau (15 February 2011)

Thanks Wayne. Good to hear from you as well!  

I am trying to work out if there is a 'competitive market' for options on the ASX or would an option buyer be pretty much a price taker.

How about if I rephrase the question:

Just say I looked at a put option for NAB during July 2010 which had an expiry date in Dec 2010.

In July 2010, let's say the previous 6 months statistical volatility was 10%. What would be a typical IV be that I could expect to buy the option at?  Would a typical put option buy price be be 20% over what my statistical volatility predicted? Or perhaps the buy price is 50% greater than predicted (trying not to confuse volatility % with price increase %).

Then, if I fastforward to expiry date, how does the July 2010 buy price IV compare to the actual statistical volatility which now can be measured?

I think I might have to do a bit of leg work and do these calculations myself.

Incidentally, I am trying to evaluate a Taleb style bet that puts on Australian banking stocks are underpriced.

Cheers,
Mark.


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## sails (15 February 2011)

Hi Mark,

Don't forget the banks have quite high dividends which subsequently affects IV readings.

Prior to ex-dividend, calls appear cheaper and puts more expensive. After xd, they go back to normal.  I would suggest studying up the effect of dividends before jumping in with the sharks!

You also ask about being a price taker.  That does depend on market depth at the time and how many other retail traders wanting to take the opposite side to you.  I haven't traded Aussie bank options for quite a while, however, I found they could be quite difficult to trade at a fair price.  If you plan to go further out in time and/or further away from the money, good chance it will be just you and the MM...

Check it out for yourself as I only have IB at this stage with one line of market depth for Aussie options.  I used to also have WebIress where detailed market depth was available making it quite easy to see where the MMs were sitting.

Yes, good to see you back too.  I just checked on your previous postings and see it has been quite a long time...


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## wayneL (15 February 2011)

markrmau said:


> Thanks Wayne. Good to hear from you as well!
> 
> I am trying to work out if there is a 'competitive market' for options on the ASX or would an option buyer be pretty much a price taker.
> 
> ...




Mark

I hope I undersatnd your question correctly.

Re stat vol.

The biggest thing to remember here is that it measures volatility realized over a set time frame. It looks backward just like any indicator (eg MACD, Stochastics etc), therefore is not predictive.

The only thing predictive is the price itself, from which we can gleen the implied volatility.

Fair value is a personal thing. If the price matches your view of future volatility, the price is fair.

That's why bog standard wisdom of buying low volatility and selling high volatility might not always make sense. Sometimes high volatility is a buy and low vol a sell, depending on what you think the stock is going to do.

Of course, a crystal ball comes in handy for these decisions. 

Re price taking:

I think you are pretty much stuck with being a price taker on Oz options whether buying or selling, though in some cases you can get away with going inside the spread.


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## markrmau (15 February 2011)

Hi Wayne and Sails - thanks for the good advice.

I found a masters thesis on the theoretical issues which should be worth a read: 

http://eprints.qut.edu.au/16325/1/Qianqian_Yang_Thesis.pdf

From you guys, it sounds like there is not a particularly liquid market over individual bank stock options. My preference (untested at this stage) is for buying well out of the money puts on bank stocks. However, if there isn't a reasonable market for these options, I may be better off going for index puts.  (Of course there may not be a market here either).

I will do a bit of my own study over the next few weeks and get back on this thread.

The bigger picture is that I think the oz house market is over priced, and at some stage, we will see a correction.  The question I would like to answer is "how do I profit if this is correct?" rather than whether the premise is correct or not in the first place.

Cheers,
Mark


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## Michael Cornips (17 February 2011)

markrmau said:


> Hi,
> 
> Just wondering if there are any studies on how closely priced ETOs (or warrants) are to Black–Scholes theoretical values?
> 
> ...




Here is a volatility chart for NAB over the past 12 months. It compares quoted market maker volatility against what the historical volatility was over the previous 30 days.


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## markrmau (18 February 2011)

Michael Cornips said:


> It compares quoted market maker volatility....




Thanks for that - very interesting.

When you say the quoted MM volatility, is this a calculation based on the midpoint of the bid-ask spread?  Or is the volatility actually quoted? 

Regards,
Mark.


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## Michael Cornips (18 February 2011)

markrmau said:


> Thanks for that - very interesting.
> 
> When you say the quoted MM volatility, is this a calculation based on the midpoint of the bid-ask spread?  Or is the volatility actually quoted?
> 
> ...




This is the explanation from our data provider: 

A background process calculates an implied volatility (where possible) separately for calls and puts in each stock/expiry combination (“series”). 

Implied volatility values are re-calculated throughout the day at the following times when option makers are most likely to be operating fully:

10.30 a.m 11.00 a.m 11.30 a.m 11.55 a.m 2.15 p.m 2.30 p.m 3.00 p.m

3.30 p.m 3.45 p.m

Calculation Method
The process selects a set of options with strike price nearest the current stock price:

This selection process typically returns 1 to 4 options. If none are selected then the nearest two strikes to the stock price are used. Strikes near the current price are selected because these options have the largest time-value, making for a more accurate (i.e. stable) volatility measurement. 

For each selected option, an implied volatility calculation is attempted. 

If a current bid/ask exists, the mid-point is used as the option price and the current market “smart last” is used as the underlying price.

The simple average of these implied volatility numbers becomes the implied volatility value.

regards Mike


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