The Skinny On Options Modeling

Option Values and Market Kurtosis

The Skinny On Options Modeling

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Viewers new to tastytrade might not know what Kurtosis is but veteran viewers know that it means that market returns have fatter tails than the normal distribution curve. Market participants know this too and as a result they often bid up out-of-the-money (OTM) options beyond what the Options Models (eg. Black-Scholes) value them. TP joins the guys to explain these concepts and what we can learn from them.

Those bidding up the options estimate the expected move will be greater than what the Model predicts. This impacts Implied Volatility (IV) and is why we see Volatility Skew. The higher demand for the options increases the price and the increased price means increased IV. This is why an option’s IV is an interpretation of its price, all other things being the same.

TP explained the IV calculation. He then elaborated and described how we use the changing IV figure to calculate probabilities and Greeks. He then further explained how we can also price the theoretical value of the option using IV, that makes its probability of expiring OTM, match the Kurtosis curve and compare the historical distribution to the market. A table listed SPY Puts and Calls that were 1%, 2%, 5% and 10% OTM. The table listed the Kurtosis theoretical value, the market price and the percentage the market price was over Kurtosis. TP used the table to show, “that based on the real fat tails that we've seen and the Kurtosis behavior of the market, that the IV that would have generated those sorts of returns. The risk premium that is embedded in options we know is always overstated and this emphasizes the point." Summing things up TP said, “My point is not that these options are overpriced. The takeaway here is you are worried about risk and you are buying insurance. What is that insurance really worth versus what they are charging you for it?”

For more information on Kurtosis see:

Watch this segment of The Skinny On Options Modeling with Tom Sosnoff, Tony Battista and Tom Preston (TP) for the key takeaways and a better understanding of Kurtosis and why since “fear is overstated” option prices tend to be overstated.

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