It’s Calculated, Option Price Sensitivity

Dmitry Pargamanik and Will McBride, the cofounders of Market Chameleon, join IBKR’s Jeff Praissman to discuss the many uses of Option Price Sensitivity Calculators  how traders can use this to their advantage as well as learn option behavior from them as an educational tool.

Summary – IBKR Podcasts Ep. 205

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi, everyone. I’m Jeff Praissman with IBKR Podcasts. It’s my pleasure to welcome back Will McBride and Dmitry Pargamanik from Market Chameleon. 

Hey guys, how are you? 

Dmitry Pargamanik 

Thanks for having us, Jeff. 

Will McBride 

Hey, Jeff, great to be back.  

Jeff Praissman 

Oh, my pleasure. I love when you guys swing by for our monthly podcast together. You guys just wrapped up a great webinar on option price calculators and today we’re just going to, as we usually do, we take a little bit of a sometimes a deeper dive, sometimes a different dive, into that subject, as well, for our podcast audience. So guys, what I’d like to do is I want to just start from the beginning with the basics. So what inputs can go into option price calculators? 

Dmitry Pargamanik

When we talk about an options price calculator, not to confuse it with an option profit calculator, which would look at an option and assume if it’s expiration and the stock is here or here, what would be the potential loss or profit of that option or its value? This looks at an option from the perspective of an option pricing model and to give it a value today. At the present. 

And for an option pricing model, you would need certain inputs that are known such as strike price, a call or a put, where the stock price is, days to expiration. However, in the model itself, some of the inputs are assumptions or estimates, like the implied volatility of the option. 

You might need to put a dividend in there if the stock pays a dividend or goes as dividend prior to expiration. You have an interest rate in there. So when we use a model and we try to estimate the value, there are known inputs and then there are unknown or estimated inputs. 

And the real benefit or why people use it is to compare the market prices that they’re observing to an estimated value based on their assumptions and to see how much they differ by. So if I had to just make an analogy, if you’re looking to buy, let’s say a brand-new construction home and it’s sitting thee and it’s beautiful, and let’s say a $500,000 home. The market value and what you could purchase it at. One way to use a model is just to compare if I bought a similar lot and I created my own inputs of what would it cost me in labor and what would it cost me in material price per foot? And I put that into the model. 

And let’s say I came up with an estimated value of $650,000. That market value all of a sudden seems like it’s a good deal. Because my model says it would cost me much more. At the same time, maybe your model says it will cost you exactly $500,000 and that would be your fair value based on your estimate. 

Or maybe your model will say hold on a second, if I did this all my own and bought a similar plot of land and put these inputs, it would be $300,000. Then you would have to take a look at that closer and see if that divergence makes sense or it’s justified. 

So that’s what the option pricing models help us do is try to put a price on the present value of something. And this also helps us compare it to the market values we observe to make better decisions. 

Jeff Praissman 

Obviously experienced traders and investors can use these calculators to test different positions and strategies. We’re going to get to that later in the podcast, but before we do, is there value in an option calculator for say beginners or people have never traded options before such as like maybe an educational tool? 

What are some ways it can be used as like a teaching tool? 

Dmitry Pargamanik 

Yeah, so I think for any trader, beginner or advanced, it’s important to have an option pricing model and calculator. And even for a beginner, I would say that it’s important to test and educate yourself and see, even by changing your inputs, what the option would look like. And I’ll give you an example. 

Like sometimes we have beginners who do trades in the very beginning and they think that the stock is going to go up. Okay, so they said, here’s a stock and I think it’s going to go from a $100.00 to $105.00 next week. So they go and buy an out of the money call, let’s say 110 strike call. Then they see that the stock actually did what they were anticipating. Outlook was correct. The stock actually performed the way they anticipated. But at the end, they see that the value of their option dropped significantly. So they bought an option $5.00 and now it’s $3.00 and then what’s going on? 

The stock went up. I bought an upside call, but I lost value in that option. And that’s what this option pricing model helps you do is test out those theories that hey, if I move forward and decrease implied volatility and even though my outlook is right, how does this option actually perform or look like in comparison to what I think it will do? 

It’s very important to educate, to test, to validate some of your theories and see if it even lines up with your outlook, given that you could change the inputs and then actually see the estimated values prior even to engaging in a trade. 

Jeff Praissman 

Yeah. I’m definitely a visual learner, so I can see how it can be really helpful to have, either of these outputs, whether they’re graphical or in a plot, showing the effect of changing the different inputs to see how the price and the Greeks are affected.  

Do calculators only work for single-leg options, or is this something that they can use for multi-leg spreads and combinations and so forth? 

Dmitry Pargamanik 

So for at least the way we use it and we created the tools that you can create strategies. And this is where it becomes very helpful that you may not even be able to do without option pricing model. And when we talk about the strategy, an option strategy like a bull call spread, it could be a condor time spread, each of those have different risk sensitivities. Especially when you start combining options as a strategy.  

And by plugging them into the option pricing model and aggregating them, you could see what is my exposure? For example, for a directional $1.00 move in the stock. We call that the Delta. If we move up a dollar, move down a dollar, what is my exposure I stand to gain or lose on that type of a move? Or if I change my assumptions and look at, moving forward, if nothing happens, how does this look like tomorrow? What is my decay? And so there are different risk sensitivities to your strategy. It could be directional, it could be decay, it could be exposure to an implied volatility move up or down. 

It could be interest rates, and this allows you to look at a more complex strategy or position and then change those different assumptions just to test out how you expect that portfolio or strategy to perform. 

Jeff Praissman 

Okay. Yeah. And staying with that same theme, as far as the inputs. Can you talk about some real-world reasons why you would be changing some of these inputs? Say, for example, what are the couple of scenarios or scenario where, you mentioned implied volatility. 

The trader would either raise it or drop it. Again, options are derivative instruments, based on price, but also other factors as well, such as implied volatility and interest rates and so forth.  

So if you could start with implied volatility like, I bought a position or positions and I want to test it, forward test it using this price calculator. 

Why would I want to drop the implied volatility?  

Dmitry Pargamanik 

Yeah, like a very common reason to change the implied volatility and move forward is around earnings. So when we look at earnings, we know that the option implied volatility premiums, they all reflect the unknown, the event, right? The catalyst events. So when we look at the option, one thing we know from history is that after the earnings event, earnings come out, the news is out, the stock reacts, and then implied volatility falls to a more normal level that doesn’t price in an event. 

When you have that scenario, you want to see if I have the implied volatility today at, let’s say 90, and I expect the implied volatility after earnings to fall to say 40, how much do I have? What is the value of that option? What will be the value of the option if I move it forward and drop it to 40? 

So of course, if I sell it and nothing happens and implied volatility drops, if you sell something and then for a higher price and you could buy back at a lower price, that would be a profit, but that’s assuming nothing else happens with the stock. 

However, the stock may move too. So you want to see those scenarios. Those different scenarios. What if the stock does move 5% and implied volatility drops from 90 to 40? Does that still look like that option will make sense in that scenario? Because at the end of the day, right, if you sell it at a price, you want to buy it at a lower price. If you buy it at a lower price, you want to sell it at a higher price. 

And that’s a way to test those theories by changing those inputs and moving your date forward. 

Jeff Praissman 

Yeah. And then obviously like days of expiration makes sense I think to most people. You just want to see how that position evolves throughout as it gets closer and closer to expiration. But what about interest rates? Like why would a user want to change those around? 

Dmitry Pargamanik 

And that’s a good point. Interest rates and then actually dividends, and then the time to expiration, but when we look at interest rates, there’s a cost of carry to a position. And that cost of carry, that’s part of the option pricing model, right? It’s an input into the option pricing model. 

And if the cost of carry goes up, how much will your positions have changed by it? Let’s say that interest rates move higher, right? The borrowing rate, look, when cost of capital goes up, what impact does that have on your position? Because the option price will change when your position will change. 

If the cost of capital goes down, interest rates move down, that will also have an impact and change. Same thing with the dividend. So there is a cost of carry component where it’s important because even if you change your dividend assumption, if you change your dividend up or down or even change the expected ex-date when the dividend will go ex-dividend, that will have an impact on the option price. So that’s important so you could test it out, especially if you’re not sure.  

If I have a longer-term option and I’m not sure where interest rates will be from then to now. Or from now until then if they can move around, you may want to change those scenarios and see how your position would change by.  

Will it go up or down and if you’re going to incur loss or profit. But also how are your other sensitivities as well? Days to expiration, that’s also important because if you have 30 days to go, nothing happens. Those options decay. And decay is not linear, decay, as you get closer, they decay faster than the options. So you want to also test that out. 

If let’s say, nothing happens and I hold it for a week. How do those options look? If the stock’s right at the same place, implied volatility is at the same place, but all I do is have the decay. You could use that to move forward and then you could compare today’s value versus one week forward and see the difference in what you have at risk. 

Jeff Praissman 

And kind of circling back to the kind of first thing we talked about as far as a teaching tool. I could really see this being, not just for traders that are actually trading positions and seeing where the risk is, but, just from what you just mentioned, you can really learn how options behave based on different inputs just by using a tool like this. That you can walk through oh, okay, there’s a dividend going to be paid. It’s going to go ex dividend during the cycle. Oh, the call is going to drop by that price of the dividend because of that, or interest rates are going to rise and the options can react in a certain way. Or, as we get closer to expiration, that time value starts decaying and that even if the stock’s remaining constant, the option’s losing value as it’s getting closer and closer. 

So I can really see the value in this as a teaching tool, again, just circling back to that. But it seems like with a lot of stuff we talk about, the tool’s only going to be as good as what you put in it. So people formulate these opinions on what’s going to happen in the market or they’re collecting data from different sources, most likely.  

Just curious for like you and Will, what are some of the ones that you find valuable as a trader? Not really specific publications, but maybe more general mediums or whatever? 

Dmitry Pargamanik 

As far as looking for data and plug it in into maybe an option price model, the most useful data source is, and when we’re talking about a specific company, let’s say, are the press releases.  

So a lot of companies will issue press releases that will indicate the ex-date and the amount of the dividend, which is an input upcoming earnings. 

That’s important because if you’re trading options, you want to know the date of binary events or events that could potentially have a larger move on the stock and larger volatility. So press releases are extremely important. The Investor Relations website is important too, because sometimes they’ll put information on their investor relations website and that might be material. 

But not issue a press release. So those are important places to go visit. And sometimes they’ll have a calendar of events on their investor relations website. You could go and they’ll give you a calendar of.. these are conferences we’re going to attend. These may be earnings. There are special dates for this. You want to be able to gather that data and have that in front of you when you’re putting together this model and taking all those into consideration.  

In addition, SEC filings. A lot of companies will file with the SEC their earnings reports, even their press releases and other information that could be material to pricing options or the stock. 

So I would say as far as an individual company goes, those are the sources of information that we always monitor. And try to go back and see if we could find any new information that we don’t have. 

Jeff Praissman 

Now that sounds good. Any final thoughts you want to leave our listeners with option price sensitivity calculators? 

Dmitry Pargamanik 

Yeah, I think if you’re a beginner, I would start really learning about how to use an option pricing model, option pricing calculator. And you don’t need to know the math necessarily to come up with your own black shows of, maybe it’ll be helpful to understand it, but you don’t really need to understand that as much as the inputs and the outputs, right? 

And what the model is trying to help you with. So there are certain things the model helps you answer. It’s not like here’s a perfect solution. Everything has risk, but it’s a way to help guide you in your decision making when you’re looking at valuation, you’re looking at risk. And it’s an important tool, especially in the long-term. 

I don’t know if you’re going to be trading in the long-term, you can’t do without it. Everybody will have an option pricing model that helps them out. So even a beginner, unless you’re thinking of just doing one trade and never doing anything again, but if you’re looking and interested in options and options markets, I would really learn how to use an option pricing model, option pricing calculator. 

Jeff Praissman 

Yeah, no, it makes total sense. And again, I want to thank you guys for coming by the studio. Like I said, we had a great webinar with you. This podcast has been great. For our listeners, you can find a ton of material from Market Chameleon on our website under Education, and you can go to Contributors and look for them for their webinars and past podcasts. Also, they run a great, I guess a daily YouTube channel show in the morning as well that you can catch on their YouTube channel. 

So again, Will and Dimitri thanks again and looking forward to seeing you guys next month. 

Will McBride 

Hey, thanks for having us, Jeff, 

Dmitry Pargamanik 

Thank you, Jeff. 

Jeff Praissman 

My pleasure.  

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