Options Pricing Ain’t Rocket Surgery

By TradeSmith Research Team

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You know what I’m thankful for this Thanksgiving week?

Just as much as the recent market liftoff putting smiles on every investor’s face… And the 20 lb. turkey sitting in my freezer… And the extra time that I’ll get with my loved ones this weekend…

I’m grateful for TradeSmith Daily readers. Call me corny if you like, but it’s true. Because every single day, you spoil me with a new inspiring email.

An investment idea (or a sanity-check on one of mine), an insightful question, just a kind note of gratitude… Or, in today’s case, something great to share with your fellow readers. All of it is welcomed and appreciated.

That’s why today, I’m following yesterday’s excellent question about options trading from TradeSmith Daily reader Joseph C. with another one, just as important.

Just how am I able to forecast options prices, as I recently have with my TLT and XLE call option recommendations?

To shamelessly borrow a newsletter-writing cliché, I don’t have a crystal ball. But the beauty of the options market is, thanks to the precise mathematical formulas that drive options prices, I don’t need one.

If you have a price target, a downside risk level, a ticker, and an expiration date, you can easily figure out where a selected call or put option will be with a corresponding stock price by any given date.

Today, I’ll show you how.

I was inspired to write this, as I hinted, from the TradeSmith Daily feedback inbox, which you can write into anytime via [email protected]. (Note that while I read every email that comes in, I’ll publish only the ones I think could best benefit your fellow readers.)

Joe W. wrote me earlier this week…

I just completed reading your very compelling release “Why Today’s Oil Prices Are a Gift” received at 1:00 p.m. ET this afternoon, and I am having trouble with the math associated with the hypothetical XLE Call Option gains as at Nov. 30, 2023, and Dec. 29, 2023.

I would be eternally grateful if you would share the calculations that generated a 45% gain in the next 18 days, and a 22% gain by year-end.

Thank you very much.

—Joe W.

Thank you very much for writing in, Joe!

Let’s set aside the fact that this trade cracked a turkey-sized egg on my face — at writing, XLE is roughly flat from my recommendation — and focus instead today on how to calculate options prices.

Learning how to do this seems a lot like becoming a rocket scientist or a brain surgeon or a… rocket surgeon. It’s high-stakes and pretty complicated.

Options prices factor in market volatility, strike prices, the time until expiration of the option contract, and the current risk-free interest rate (i.e., Treasury yields), and a whole bunch of other complicated, uncertain, constantly changing things.

All these factors feed into the Black-Scholes model, which has been used for 50 years as the premier method for pricing derivatives like options.

To all my fellow traders who failed college algebra, avert your eyes. Because this is what the Black-Scholes model looks like when applied to a call option contract:

Source: Investopedia

Now, I hope you know me well enough by now to know I’m not breaking out a napkin and a Bic pen to work this out every time I trade an option.

Fortunately for me and other mathematically impaired traders, the advent of computers and the internet have taken all the hard work out of using the Black-Scholes pricing model to trade options. Now, we have a shortcut to becoming options rocket surgeons.

Here’s my dirty little secret, Joe: Options pricing calculators. Here’s the one I’ve been using: www.optionsprofitcalculator.com Pick a strategy, plug in a ticker, select an option and a rough price range, and boom — you have an idea of where options prices will be depending on when and how much the stock moves.

Let’s revisit that XLE call trade, for example. On Nov. 12 I pointed out the $82 call option expiring on Dec. 29 was trading at $3.65 per contract. Today, with the continued slide in XLE, the option is trading at $2.99.

Last week I based my trade idea on oil futures, which muddied the waters a bit. This time let’s bring up a chart of XLE.

As I write on Thursday evening, XLE is near two support lines:

  1. The long-term horizontal support level around $82.09, which it traded intraday Thursday,
  2. And the recent white downtrending support line, which it also hit intraday.

Now though, looking at the XLE chart, we can see more of a bullish pattern emerging, rather than the downtrend channel we saw in oil futures.

For the sake of the example, let’s say XLE will jump or fall 5% from here. Either it breaks down from support and falls toward the recent lows around $78.75, or bounces hard and rallies to $87, resolving the bullish pattern to the upside.

That’s enough information to put into the options pricing calculator and get an idea of what to expect until the option expires. Let’s plug in $87 and $78 as our upside and downside targets and use the Dec. 29 $82 XLE call option.

In return, we get a matrix showing the percentage gain needed to reach each price (right y-axis) and the percentage gain the option will return (the colored cells) at each price (left y-axis) every couple days until expiration (top x-axis).

On the website, you can also hover over each colored cell to see the cash return. (For an interactive version of the below chart, click here.)

Secret’s out: I’m no Rain Man. This is how I figured out where options prices would be under the scenarios I described in both of those recent recommendations.

But frankly… I’d rather be resourceful than Rain Man.

Knowledge is power. And knowledge comes from deliberate, careful research.

That is to say, Google (the search engine, not the company) is your friend. If you’re ever stumped on an investing concept like options pricing, and I haven’t yet written about it here in TradeSmith Daily, don’t hesitate to see what information is out there on the world wide web.

Now of course, this calculator technique will only tell you where the options price will be under a wide array of scenarios. It doesn’t show you the likelihood of those scenarios happening. For that, you’ll definitely want the Predictive Alpha toolset on your side.

Predictive Alpha is TradeSmith’s latest, greatest trading innovation. It uses a proprietary AI engine to determine, with startling accuracy, where any stock’s price will be over the coming month.

Just as an example, here’s what the Predictive Alpha Options algorithm says about XLE:

Predictive Alpha, unlike a few of you, happens to agree that we’ll see higher XLE prices over the next month: about 1.62% higher.

And on the Predictive Alpha Options tool, we can see that it recommends buying and writing covered calls, selling puts, and trading bull spreads — all bullish strategies.

To your health and wealth,

Michael Salvatore
Michael Salvatore
Editor, TradeSmith Daily