February 1, 2024 • 32 mins
For those new to options, certain aspects of pricing are difficult to understand. And for those more seasoned traders, even they might be left “in the dark” when it comes to the behind the scenes mechanics of OCC pricing determinations. Luckily, OIC has both covered. Join host Mark Benzaquen as he welcomes fellow OIC instructor Ken Keating and OCC Director Colin Fisher to discuss pricing basics and OCC’s margining processes in this lively and informative episode, sure to interest investors of all experience levels.
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Now here's your host, Mark Benzoquin.
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Hello everyone and welcome to OIC's Wide World of Options.
I'm your host, Mark Benzoquin, and I wanted to pick up where we left off last month as
we continue our options journey by talking about pricing this time around.
For today's episode, we're fortunate to have two guests with us tackling pricing but from
two different perspectives, which I think is interesting.
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So to start, we've got my friend and colleague, Ken Keating, in the studio with me today,
and we're going to look at pricing from an investor's perspective.
So Ken, welcome back and thanks for joining me.
Thank you, Mark.
I'm happy to be here today.
So Ken, let's start at the beginning and we're going to talk about pricing and look at some
of the things that you're going to be covering in your upcoming February webinars.
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So to begin, let's start with where option prices come from and who makes the determination
as to what an option might be worth.
Sure.
So when you're looking at options pricing, what you're really looking at is the crowd-sourced
prices of the bids and offers for options at that particular point in time.
Now when you're talking bids and offers, a bid is what an investor or the market is willing
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to pay for the contract and the offer is what they're willing to sell it for.
Correct.
So let's say you pull up your favorite stock and you look at an options chain and you see
the market on a call is $1 bid offered at 120, $100 up, meaning that there's 100 contracts
on the bid, there's 100 contracts on the offer.
So you know at any given time, right now, well, at least at this point in time, you
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can sell 100 contracts for a dollar and you could buy 100 contracts for $1.20.
So that's what's known as the bid-ask spread.
So the midpoint is $1.10.
So in trader speak, we would call that fair value.
So it's fair value at 110, traders are willing to buy it for a dollar, but at the same time,
sell it at 120.
So when I was a market maker, I was making a two-sided market.
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I was willing to buy that option for a dollar and at the same time sell it for $1.20.
So theoretically, whether I buy it or sell it, I get 10 cents of edge on either side
of the trade.
That's how a market maker makes their money.
They're not playing direction or, you know, well, some traders play direction, but you
know, traders trade for edge and that's what they're trading.
They're trading that bid-ask spread and hedging it off with options and other stock throughout
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the day to theoretically lock in that edge.
Okay.
I'm glad that you brought up that fair value, that midpoint, because that's something that
we're going to get into in the second half of our discussion today.
So what you're telling us is that the pretty much any market participant, whether it's
an investor, a market maker, a hedge fund, what have you, those market participants all
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submit their bids and their offers to the exchange.
The exchange then disseminates the best bid or offer to the public and that's what we
see on our option chains and that's what we go trade for or trade off of.
Correct.
So let me ask you this.
If we've got, if we're looking at say a $50 strike and stock is trading for $55, so the
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call is what we call in the money because theoretically we can purchase the underlying
security in this case for $50 when it's trading $55 in the market.
So we call that in the money.
If that option is trading for $7, what can the investor discern from that $7 price as
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to the value of the option?
$5 of that is going to be in the money, right?
Correct.
And what about the rest?
So $5 of that $50 call with a stock trading $55 would be called intrinsic value.
So it's in the money by $5 because it's the right to buy that stock at $50 even though
it's trading for $55.
So intrinsically it's worth $5.
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That's also known as parity.
We'll talk a little more about that in my second presentation the following week.
But the extra $2, okay, because the option is trading for $7, so the difference between
$7 and its intrinsic value of $5, that's $2.
That's the amount of extrinsic value that is in the option.
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So we would call that the time premium left in the option.
So an in the money option has both intrinsic and extrinsic value, whereas say an at the
money or an out of the money option is comprised of nothing but extrinsic value.
It has no intrinsic value.
So not all options have both intrinsic and extrinsic value, only in the money options
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have both.
Okay.
Yeah.
And that extrinsic value, that time value, the reason we call it time value or time premium
is because it represents the timeframe for something to either go right or wrong in the
market.
Meaning if I'm buying an option six months out, in addition to paying the intrinsic value
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of the contract, if any, I'm also in a sense renting that option for the next six months
for hopefully things to go my way.
And as that six months decreases, goes from six months to five months, et cetera, et cetera,
that time value is going to shrink, right?
And that's what we call time decay.
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Right.
So, you know, an options premium, an option is a wasting asset.
So every time we, every day we get closer and closer to expiration, it loses a little
bit of value.
But it only loses the time premium portion of that option, the extrinsic value.
The intrinsic value stays, okay?
It's the extrinsic value that is subjected to time decay or theta.
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Your Greek theta is how much your option is expected to lose on a daily basis, but it's
that extrinsic value that decays, not the intrinsic value.
Okay.
And then the phrase time is money, something that obviously we're all very familiar with.
That applies to options as well.
If I'm a seller and I'm going to be selling a contract, I have an idea what my risk is
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with the options expiring tomorrow, right?
I have an idea of what's going to happen in the market over the next 24 hours.
I have no idea what's going to happen over the next two years.
So as we go further out in time, those options are going to cost more money, right?
Absolutely, because time is money and the more time that you pay for, the more it's
going to cost you.
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So obviously an option that expires in a week is going to cost less than an option that
expires in two years.
Mm-hmm.
So the more time that's embedded in that option, the more time premium is in that option.
And likewise, the more expensive that option will be in terms of price.
Right.
So the further we go out in time, I look at it from a seller's perspective that as a seller,
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I've got significantly more risk on my hands going out two years in the market versus going
out two days.
So as a seller, because I've got so much more risk, in order for me to accept that risk,
I'm going to need significantly more premium to do so.
Exactly.
And there's all kinds of moving parts when it comes to options.
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And Vega, your option sensitivity to changes in volatility is probably one of the most
important factors.
But as your options get further and further out on the curve, they're more Vega sensitive.
So not only do you have to worry about movement on stocks, say if you're short options, you
have to worry about implied volatility.
If the stock pays a dividend or not, you might have to worry about a dividend.
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You're more sensitive to interest rate changes.
So the further out you go, all these factors come into play at varying levels.
And those factors, those moving parts that you're talking about, those are the different
components that go into that options price.
Can you tell us what those moving parts are, what those variables are?
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Sure.
So how do you put the variables that go into a pricing model?
There's the stock price, there's your strike price, there's your time to expiration, how
much time is left in that option.
There is interest rates, there are dividends if the stock pays a dividend, and then there's
implied volatility.
Now out of all those factors, most of those are pretty much known, right?
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So at any given time, we know what the stock price is trading for.
We know what our strike price is.
Interest rates, we kind of have an idea what they are today.
We can kind of anticipate what they might be in the future.
So those are kind of somewhat known.
Dividends gets a little more dicey further out.
We don't know if a company is going to continue to pay dividends or increase them or decrease
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them.
But the implied volatility, that's the wild card in options pricing.
It's what all traders are trying to solve for, and it's based on the supply and demand
for options.
If options get bid up, there's more demand than supply.
Traders would say implied volatility, naturally those prices would get bid up higher.
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We would say that implied volatility is going higher.
So one way to look at implied volatility is to equate it to options prices.
So as option prices are expensive and they get bid up, you can infer that implied volatility
is expensive, is getting bid up.
And likewise, if there's a bigger supply of options, then demand prices will go lower.
And that will naturally result in lower implied volatility and lower prices.
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And implied volatility is such an important aspect of options pricing that we devote a
large section of our website, or I should say we've got a tremendous amount of content
on our website dedicated to implied volatility.
So while it's a more intermediate concept than what we're talking about here with options,
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basic and basics of pricing, it's a very, very important concept to know.
And so for listeners, I definitely encourage you to go to our website and take a look at
all of the information that we have on implied volatility, as well as the Greeks, which Ken
had just mentioned.
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So Ken certainly appreciate that overview on options pricing.
I want to encourage everyone to go to our website, optionseducation.org.
Check out the events section on the page and register for Ken's two upcoming February webinars.
He's going to be taking a much deeper dive than the high level overview that we just
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covered, as well as talking about some different things that we didn't talk about today that
he will be addressing in his webinar.
Ken let's get off topic for a second.
I've been in the business 25 plus years.
I know our colleagues at OCC, those of us on the investor education desk certainly have
a very long history and experience in options.
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You're no different.
Let's take a minute.
Tell me about what got you into the market.
What got you into options?
More importantly, how about this?
What was your impression of your first day on the trading floor?
What were things that were going through your head?
Oh my God.
So my first day on the trading floor, it's like sensory overload.
And when was this back in the mid nineties?
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I'm guessing.
Yeah, this was 1992.
Oh, early.
1992.
Yeah.
So I basically started out as a clerk on the floor of the Pacific Coast Stock Exchange.
And I got the job.
It's funny because I was, I was bartending at the time.
I was always interested in trading numbers.
The stock market always fascinated me, but I never really knew how to get into the business.
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And I was working at this restaurant and I was opening the bar that I was working in.
And I, these two guys that I had known forever, I hadn't seen them in years.
They came in and they started drinking at like two o'clock in the afternoon in San Francisco.
Yeah.
And I'm like, yeah, it's great seeing you guys, but you know, once you guys get a job
or something, like what are you guys doing here drinking in the middle of the afternoon?
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They said, Oh, we just got off of work.
I said, really, what do you do?
And they explained to me, they're working for market makers.
I said, what's a market maker?
And I realized that there was a trading floor in San Francisco.
And I thought, well, maybe that's what I want to do.
So I went and I applied to every trading firm on the floor of the Pacific Coast Stock Exchange.
And one clearing firm hired me.
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A clearing firm is basically a bank for traders.
So if you're trading your own money, you deposit money at a clearing firm, they clear and set
all your trades and run your sheets for you.
And you know, they're basically your bank.
And I worked for the clearing firm running sheets and executing futures orders and executing
buying sell stock orders, things like that.
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And then I ended up befriending a partner at one of the trading firms in San Francisco.
And he said, you know, I was executing stock, NASDAQ stocks, buying and selling in the Microsoft
pit and buying and selling stocks to hedge the traders in the pit.
And he looked at me, he said, Hey, why don't you come work for us?
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We'll pay you a little more.
You do exactly the same thing.
And I said, done.
So I basically ended up working for this trading firm and they put me through their training
program and I became a trader and the rest is history.
Excellent.
Yeah.
The rest is history for sure.
Yeah.
Yeah.
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That's wonderful.
Yeah.
Excellent, Ken.
Thank you so much for sharing that.
And for listeners interested in attending Ken's February webinars, you can do so via
the event section of our OIC website, optionseducation.org.
I highly encourage everyone to register and attend.
Ken's going to be covering a great deal more information than our time allowed for today.
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He's going to be taking a deeper dive into pricing, talk about different pricing models,
which transitions nicely into my next guest, Colin Fisher from OCC's pricing and margins
team.
Colin, welcome to the show.
Hey, thanks for having me.
I'm excited to be here.
Yeah, Colin, thank you.
Listen, Ken just explained pricing from an investor's perspective.
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Let's take a look at the flip side of the coin.
Let's look behind the scenes and look at pricing from an operational perspective.
So to start, Ken and I were talking about those bid ask markets, right?
What you can buy an option for, what you can sell it for, et cetera.
But the reason that's important is because people call us or I should say people email
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us or chat with us on our website, the investor education team.
We get a lot of questions about what is the closing price of options, XYZ, $50 strike
that expiring tomorrow, et cetera.
The reason I bring that up is because as we hear internally at OCC, no, options don't
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have closing prices.
They have those closing bid ask markets that Ken had talked about.
So with that on the table, so to speak, we also know that OCC computes a theoretical
value for each and every option contract each and every day that the market is open.
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And these are called mark prices that OCC uses to, among other things, margin our clearing
firms that Ken had mentioned.
So what can you tell us about that in terms of OCC mark prices?
Why does OCC create these mark prices and how do they calculate them?
How do they arrive at these values?
Yeah, so there's I think 17 different exchanges now, options exchanges, and most products
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are dual listed.
So because of that, you may have different closing prices on different exchanges for
the same option strike for that same product.
So what OCC's role is, is to create one mark price for each strike and each product so
that you have the same price at the end of each day for an option contract.
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So that's one of the ways, that's the main reason why we do that.
Okay, now let me ask you this.
So we do these mark prices kind of to smooth out the, you know, any pricing variances between
exchanges or something like that.
So how does, well, let me ask you this, how does OCC arrive at these?
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I know that, you know, we've got a proprietary algorithm that we use.
What are some of the, can we talk about, even though it's proprietary, can we talk about
some of the different inputs that we use for these prices?
Yeah, so the smoothing algorithm, it is proprietary, but it's based on the Black-Scholes model.
You know, how the model works is it will take the best bid and the best ask from all 17
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exchanges and what it does is it creates a price and a volatility at each strike.
Then once that's determined through an iterative process, it will smooth it out to make it
like a smooth volatility curve.
So instead of having like a jagged curve because maybe a bid ask is wider on one strike and
tighter on another strike, it goes through this iterative process to make a smooth curve
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of volatility.
And so some of the prices might change a little bit.
Why we do that is to create a volatility curve which creates prices that are free of arbitrage,
satisfied put-call parity, no monotonicity issues, meaning that puts should all go down
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from the highest strike to the lowest strike, calls should all go up or should all go, yeah,
vice versa, as you understand what I'm saying.
Right.
So as call strikes go lower, the price gets more expensive.
As put prices, I'm sorry, as put strikes go up, the put prices get more expensive.
So OCC does all of this smoothing to ensure that, for example, you know, maybe there's
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a bid ask of, you know, something kind of out of whack, you know, maybe in, you know,
three months down the road.
So what we do is we kind of look at that and while we're cognizant of that, we don't necessarily
let that affect all of the other prices in this security.
And we do this for every single option, every single strike, every single month or expiration
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date, and we do this every single trading day.
Every single trade.
Right.
1.5 million options.
1.5 million options.
Yeah.
So one of the reasons, you know, we do get, you know, some questions, some of them come
from you guys and people will say, "Well, how come you just don't use the midpoint of
the bid ask?"
Right.
And so when you have some of these very liquid stocks, that might work perfectly fine.
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You could use the midpoint.
And usually you'll find that our theoretical mark prices are right in line with those midpoints
for those types of securities.
Okay.
It's the securities that are less liquid.
And by liquidity, what we're talking about, liquidity we're talking about volume, maybe
open interest for options, things like that.
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Liquidity isn't something that we generally talk about here at OCC because it's so subjective
for so many people.
But what you're talking about are the more heavily traded securities versus securities
that aren't so heavily traded.
Yeah.
And the ones that aren't heavily traded might not have as many market makers.
Right.
And you have less people making markets in those as well.
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And so the more market makers you have in a security, the tighter and more efficient
that market will tend to be.
Right.
Right.
So the competition kind of squeezes down those bid ask, make the tighter markets kind of
easier to figure out pricing for something like that versus a security that may not trade,
not even every day, but may not even trade every week.
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Yes.
And for example, one of the things that people ask us at Investor Education is, well, I see
the last price for XYZ was $3, and yet you're valuing it at a dollar.
What people don't realize is that last traded price may have been three weeks ago.
Yes.
Or it could have been six months ago.
So that last traded price is kind of irrelevant.
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But what I thought was interesting when it comes to pricing, those, that 29 point model,
some of the inputs that we look at aren't just that particular strike.
We're not looking at the $50 XYZ call expiring at three weeks.
We're looking at the $45 call.
We're looking at the $55 call.
We're looking at it expiring three months from now and six months from now.
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And that, all of those inputs goes into that, you know, soup that gives us the price for
that XYZ $50 call expiring at three weeks.
That's correct.
That's why it's a smoothing algorithm.
Right.
So it's taking all those bids and asks, and it's trying to find a nice smooth curve.
Right.
Irrelevant if you have bid and asks that are wider on certain strikes than others within
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that given month.
Each month is smoothed itself though.
So you do not go from smoothing a November set of contracts with your January.
It is each month separately.
And there's reasons for that, right?
You're going to have dividends that land in a certain month.
Yeah, good point.
You're going to have a plan in a given month and then you're going to have, you know, your
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interest rates are going to be different throughout that curve, your interest rate curve.
So yeah, there's a lot of different reasons for that.
But you know, I think, you know, you brought up the last traded price thing and it's a
good question and we get it quite often.
They buy a call for $5 at $2.30.
It never, let's say it never trades again, you know, and we'll get an email saying, well,
no one ever traded it.
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I traded it at $2.30.
How come we're not marking it at $5?
That's where I traded it.
Someone might have rallied $4 in that 30 minutes and it's a 50 delta call and that option actually
should be worth $7.
So to manage the mark to market and manage the risk of the portfolios, you really need
to recalculate all the option prices with the end of day closing price.
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Okay.
And the end of day closing price, you're talking about the closing price of the security.
Yep, exactly.
So let me ask you this.
We got the bid ask, do we ever use prices that are marked prices ever calculated outside
of that bid ask?
From time to time.
So we have, you know, like I said, we have 1.5 million options.
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We are within the best bid and best ask at a very, very high percentage.
We do go through a review process on PNM where if there's a number of options outside of the
bid ask that my team will look into that.
It could have to do with a dividend, a dividend forecast.
It could have been incorrect from the vendor.
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So we look into all those different things to see why are prices slightly outside of
the MBBO and we'll look into those.
But because there's not that many, you know, my team spends two hours a night looking into
those.
Okay.
And let me ask you this, how about, does it affect the option price, the trading cutoff?
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So for example, we've got some securities trade to 3 p.m. Chicago time, some trade to
3.15 Chicago time.
Some of those 3.15 securities on expiration, they may, those contracts may cease trading
at 3 p.m.
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How does all that work and how does OCC take all that into account?
Yeah, that's a good question.
So a lot of the ETFs tend to trade till 3.15.
The underlying actually closes at 3 p.m.
And one of the key inputs to the smoothing algorithm is end of day best bid and ask.
So using a 3.15 bid and ask and then aligning it with a 3 o'clock close doesn't make any
(26:23):
sense.
So we worked with our exchanges, SIBO and NASDAQ, both supply us with 3 o'clock snapshots
of the bid and ask from their market makers that we use to align it with the 3 o'clock
close.
So it's a special file that comes in just for those products.
And then you can compare apples to apples instead of using a 3.15 bid ask with 3.15.
(26:46):
Oh, that makes sense.
I like that.
All right, Colin, excellent.
Thank you for that.
Let me just ask you one more question.
We were talking about bid and ask and how those inputs are used for two of the inputs
that go into figuring out what an option is worth.
What if there is no bid and ask?
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For example, with the flex contract, which for those of you that don't know, a flex contract
is simply a customized contract that an investor can customize the terms in terms of the strike
price, expiration date, whether it settles in the morning or the afternoon, et cetera.
But because they're not publicly quoted, there is no public bid and ask.
(27:28):
So how does OCC derive prices for a flex contract?
Yeah, that's a great question.
So we use what's called interpolation or extrapolation from our standard contracts, which do have
bid asks.
So in the example of, let's say there's a flex contract that someone came up with a
150-150 strike, a strike that doesn't exist.
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And they want to have that contract go out to February 6th.
What would happen is the smoothing algorithm will smooth its standard contracts on February
9th.
And what it will take is it will take the implied volatility in Greeks and it will use
those standard contracts to come up and try to fit that 150-150.
So what it will do is probably look very close at the 150 strike and take a lot of the characteristics
(28:12):
in the 150 strike, the standard 150 strike, and extrapolate or interpolate those to the
flex contract.
And that's all part of the smoothing process.
Okay, interesting.
Well, thank you.
Colin, really terrific news, terrific information.
We love to get information from people behind the scenes.
(28:32):
Ken and I were always kind of more of an external participant in the market, and we still pretty
much are.
But it's interesting to see how things work from operational perspectives behind the scenes.
So thank you for sharing your expertise with that.
We certainly appreciate it.
Let's shift gears for a second.
You've been in the business for a very long time.
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You just told me earlier before we went on the air that you've been with OCC for 10 years
now.
Tell me about your history in the markets.
How did you get your start?
Yeah.
So I went to the University of Illinois, Chicago.
Just a few miles from here.
And graduated in '99.
As you guys know, that was kind of the dot-com boom.
(29:16):
I think the NASDAQ was up like 800% from '95 to 2000.
So it was kind of a good time to get into the markets.
And I knew someone at the CBOE, and he said I'd come down and clerk, so I started going
down there my sophomore year of college.
Clerked for two years.
Anytime they'd let me down there.
Work Christmas, anytime I had a break.
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Joined the firm when I graduated and started trading pretty much right away.
I was there for eight years, then went upstairs in stream quotes for three years.
I went over to CME in stream quotes and soybeans and wheat for three more years prior to coming
to OCC.
To OCC.
Yeah.
It's funny.
Pretty much anyone in the business from the trader's side of it is a journeyman.
(30:04):
Everything that we go from firm to firm to firm to firm throughout our career, we're
still doing the same thing, just maybe wearing a different trading coat.
So yeah, interesting to see that your experience kind of aligns and matches up with ours.
So excellent, great information.
Thank you for sharing that.
Thanks for sharing that behind-the-scenes perspective.
(30:24):
And thanks to all of our listeners and supporters out there.
Lastly, I want to again remind everyone to register for Ken's upcoming pricing sessions.
And as always, please feel free to send us your questions via email at options@theocc.com
or live chat with us on our website, optionseducation.org.
(30:46):
Thanks again for joining us, everyone.
Take care and we'll be talking with you again very soon.
You've been listening to the Options Industry Council's wide world of options.
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(31:10):
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(31:37):
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(32:02):
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(00:22):
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(00:52):
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This is the Options Industry Council's Wide World of Options.
Before we start today's show, listeners should know that options involve risk and are not
suitable for all investors.
(01:13):
Individuals should not enter into an options transaction until they have read and understood
the disclosure document, characteristics and risks of standardized options, available by
visiting theocc.com or by contacting your broker, any exchange on which options are traded,
or the Options Clearing Corporation at 125 South Franklin Street, No. 1200, Chicago,
(01:34):
Illinois 60606.
The Options Industry Council is an industry resource provided by the Options Clearing
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Any strategies discussed are strictly for illustrative and educational purposes only, and are not
to be construed as an endorsement or solicitation to buy or sell securities.
Commissions, fees, margins, interest and taxes have not been included in any of the examples
(01:57):
used in this show.
These costs impact the outcome of all stock and options transactions.
Consult your tax advisor about any potential consequences.
OIC was created in 1992 to educate investors and their financial advisors about the benefits
and risks of exchange traded equity options, and the Wide World of Options radio show is
(02:18):
one of several resources investors can utilize to learn more about options.
Other resources OIC offers include webinars, articles and self-guided options related coursework.
For more information, check out www.optionseducation.org.
Now here's your host, Mark Benzoquin.
(02:42):
Hello everyone and welcome to OIC's Wide World of Options.
I'm your host, Mark Benzoquin, and I wanted to pick up where we left off last month as
we continue our options journey by talking about pricing this time around.
For today's episode, we're fortunate to have two guests with us tackling pricing but from
two different perspectives, which I think is interesting.
(03:02):
So to start, we've got my friend and colleague, Ken Keating, in the studio with me today,
and we're going to look at pricing from an investor's perspective.
So Ken, welcome back and thanks for joining me.
Thank you, Mark.
I'm happy to be here today.
So Ken, let's start at the beginning and we're going to talk about pricing and look at some
of the things that you're going to be covering in your upcoming February webinars.
(03:24):
So to begin, let's start with where option prices come from and who makes the determination
as to what an option might be worth.
Sure.
So when you're looking at options pricing, what you're really looking at is the crowd-sourced
prices of the bids and offers for options at that particular point in time.
Now when you're talking bids and offers, a bid is what an investor or the market is willing
(03:49):
to pay for the contract and the offer is what they're willing to sell it for.
Correct.
So let's say you pull up your favorite stock and you look at an options chain and you see
the market on a call is $1 bid offered at 120, $100 up, meaning that there's 100 contracts
on the bid, there's 100 contracts on the offer.
So you know at any given time, right now, well, at least at this point in time, you
(04:11):
can sell 100 contracts for a dollar and you could buy 100 contracts for $1.20.
So that's what's known as the bid-ask spread.
So the midpoint is $1.10.
So in trader speak, we would call that fair value.
So it's fair value at 110, traders are willing to buy it for a dollar, but at the same time,
sell it at 120.
So when I was a market maker, I was making a two-sided market.
(04:34):
I was willing to buy that option for a dollar and at the same time sell it for $1.20.
So theoretically, whether I buy it or sell it, I get 10 cents of edge on either side
of the trade.
That's how a market maker makes their money.
They're not playing direction or, you know, well, some traders play direction, but you
know, traders trade for edge and that's what they're trading.
They're trading that bid-ask spread and hedging it off with options and other stock throughout
(04:58):
the day to theoretically lock in that edge.
Okay.
I'm glad that you brought up that fair value, that midpoint, because that's something that
we're going to get into in the second half of our discussion today.
So what you're telling us is that the pretty much any market participant, whether it's
an investor, a market maker, a hedge fund, what have you, those market participants all
(05:23):
submit their bids and their offers to the exchange.
The exchange then disseminates the best bid or offer to the public and that's what we
see on our option chains and that's what we go trade for or trade off of.
Correct.
So let me ask you this.
If we've got, if we're looking at say a $50 strike and stock is trading for $55, so the
(05:47):
call is what we call in the money because theoretically we can purchase the underlying
security in this case for $50 when it's trading $55 in the market.
So we call that in the money.
If that option is trading for $7, what can the investor discern from that $7 price as
(06:09):
to the value of the option?
$5 of that is going to be in the money, right?
Correct.
And what about the rest?
So $5 of that $50 call with a stock trading $55 would be called intrinsic value.
So it's in the money by $5 because it's the right to buy that stock at $50 even though
it's trading for $55.
So intrinsically it's worth $5.
(06:29):
That's also known as parity.
We'll talk a little more about that in my second presentation the following week.
But the extra $2, okay, because the option is trading for $7, so the difference between
$7 and its intrinsic value of $5, that's $2.
That's the amount of extrinsic value that is in the option.
(06:51):
So we would call that the time premium left in the option.
So an in the money option has both intrinsic and extrinsic value, whereas say an at the
money or an out of the money option is comprised of nothing but extrinsic value.
It has no intrinsic value.
So not all options have both intrinsic and extrinsic value, only in the money options
(07:13):
have both.
Okay.
Yeah.
And that extrinsic value, that time value, the reason we call it time value or time premium
is because it represents the timeframe for something to either go right or wrong in the
market.
Meaning if I'm buying an option six months out, in addition to paying the intrinsic value
(07:34):
of the contract, if any, I'm also in a sense renting that option for the next six months
for hopefully things to go my way.
And as that six months decreases, goes from six months to five months, et cetera, et cetera,
that time value is going to shrink, right?
And that's what we call time decay.
(07:55):
Right.
So, you know, an options premium, an option is a wasting asset.
So every time we, every day we get closer and closer to expiration, it loses a little
bit of value.
But it only loses the time premium portion of that option, the extrinsic value.
The intrinsic value stays, okay?
It's the extrinsic value that is subjected to time decay or theta.
(08:18):
Your Greek theta is how much your option is expected to lose on a daily basis, but it's
that extrinsic value that decays, not the intrinsic value.
Okay.
And then the phrase time is money, something that obviously we're all very familiar with.
That applies to options as well.
If I'm a seller and I'm going to be selling a contract, I have an idea what my risk is
(08:44):
with the options expiring tomorrow, right?
I have an idea of what's going to happen in the market over the next 24 hours.
I have no idea what's going to happen over the next two years.
So as we go further out in time, those options are going to cost more money, right?
Absolutely, because time is money and the more time that you pay for, the more it's
going to cost you.
(09:04):
So obviously an option that expires in a week is going to cost less than an option that
expires in two years.
Mm-hmm.
So the more time that's embedded in that option, the more time premium is in that option.
And likewise, the more expensive that option will be in terms of price.
Right.
So the further we go out in time, I look at it from a seller's perspective that as a seller,
(09:26):
I've got significantly more risk on my hands going out two years in the market versus going
out two days.
So as a seller, because I've got so much more risk, in order for me to accept that risk,
I'm going to need significantly more premium to do so.
Exactly.
And there's all kinds of moving parts when it comes to options.
(09:46):
And Vega, your option sensitivity to changes in volatility is probably one of the most
important factors.
But as your options get further and further out on the curve, they're more Vega sensitive.
So not only do you have to worry about movement on stocks, say if you're short options, you
have to worry about implied volatility.
If the stock pays a dividend or not, you might have to worry about a dividend.
(10:11):
You're more sensitive to interest rate changes.
So the further out you go, all these factors come into play at varying levels.
And those factors, those moving parts that you're talking about, those are the different
components that go into that options price.
Can you tell us what those moving parts are, what those variables are?
(10:32):
Sure.
So how do you put the variables that go into a pricing model?
There's the stock price, there's your strike price, there's your time to expiration, how
much time is left in that option.
There is interest rates, there are dividends if the stock pays a dividend, and then there's
implied volatility.
Now out of all those factors, most of those are pretty much known, right?
(10:56):
So at any given time, we know what the stock price is trading for.
We know what our strike price is.
Interest rates, we kind of have an idea what they are today.
We can kind of anticipate what they might be in the future.
So those are kind of somewhat known.
Dividends gets a little more dicey further out.
We don't know if a company is going to continue to pay dividends or increase them or decrease
(11:17):
them.
But the implied volatility, that's the wild card in options pricing.
It's what all traders are trying to solve for, and it's based on the supply and demand
for options.
If options get bid up, there's more demand than supply.
Traders would say implied volatility, naturally those prices would get bid up higher.
(11:37):
We would say that implied volatility is going higher.
So one way to look at implied volatility is to equate it to options prices.
So as option prices are expensive and they get bid up, you can infer that implied volatility
is expensive, is getting bid up.
And likewise, if there's a bigger supply of options, then demand prices will go lower.
And that will naturally result in lower implied volatility and lower prices.
(12:01):
And implied volatility is such an important aspect of options pricing that we devote a
large section of our website, or I should say we've got a tremendous amount of content
on our website dedicated to implied volatility.
So while it's a more intermediate concept than what we're talking about here with options,
(12:24):
basic and basics of pricing, it's a very, very important concept to know.
And so for listeners, I definitely encourage you to go to our website and take a look at
all of the information that we have on implied volatility, as well as the Greeks, which Ken
had just mentioned.
(12:45):
So Ken certainly appreciate that overview on options pricing.
I want to encourage everyone to go to our website, optionseducation.org.
Check out the events section on the page and register for Ken's two upcoming February webinars.
He's going to be taking a much deeper dive than the high level overview that we just
(13:06):
covered, as well as talking about some different things that we didn't talk about today that
he will be addressing in his webinar.
Ken let's get off topic for a second.
I've been in the business 25 plus years.
I know our colleagues at OCC, those of us on the investor education desk certainly have
a very long history and experience in options.
(13:27):
You're no different.
Let's take a minute.
Tell me about what got you into the market.
What got you into options?
More importantly, how about this?
What was your impression of your first day on the trading floor?
What were things that were going through your head?
Oh my God.
So my first day on the trading floor, it's like sensory overload.
And when was this back in the mid nineties?
(13:49):
I'm guessing.
Yeah, this was 1992.
Oh, early.
1992.
Yeah.
So I basically started out as a clerk on the floor of the Pacific Coast Stock Exchange.
And I got the job.
It's funny because I was, I was bartending at the time.
I was always interested in trading numbers.
The stock market always fascinated me, but I never really knew how to get into the business.
(14:12):
And I was working at this restaurant and I was opening the bar that I was working in.
And I, these two guys that I had known forever, I hadn't seen them in years.
They came in and they started drinking at like two o'clock in the afternoon in San Francisco.
Yeah.
And I'm like, yeah, it's great seeing you guys, but you know, once you guys get a job
or something, like what are you guys doing here drinking in the middle of the afternoon?
(14:34):
They said, Oh, we just got off of work.
I said, really, what do you do?
And they explained to me, they're working for market makers.
I said, what's a market maker?
And I realized that there was a trading floor in San Francisco.
And I thought, well, maybe that's what I want to do.
So I went and I applied to every trading firm on the floor of the Pacific Coast Stock Exchange.
And one clearing firm hired me.
(14:55):
A clearing firm is basically a bank for traders.
So if you're trading your own money, you deposit money at a clearing firm, they clear and set
all your trades and run your sheets for you.
And you know, they're basically your bank.
And I worked for the clearing firm running sheets and executing futures orders and executing
buying sell stock orders, things like that.
(15:16):
And then I ended up befriending a partner at one of the trading firms in San Francisco.
And he said, you know, I was executing stock, NASDAQ stocks, buying and selling in the Microsoft
pit and buying and selling stocks to hedge the traders in the pit.
And he looked at me, he said, Hey, why don't you come work for us?
(15:37):
We'll pay you a little more.
You do exactly the same thing.
And I said, done.
So I basically ended up working for this trading firm and they put me through their training
program and I became a trader and the rest is history.
Excellent.
Yeah.
The rest is history for sure.
Yeah.
Yeah.
(15:57):
That's wonderful.
Yeah.
Excellent, Ken.
Thank you so much for sharing that.
And for listeners interested in attending Ken's February webinars, you can do so via
the event section of our OIC website, optionseducation.org.
I highly encourage everyone to register and attend.
Ken's going to be covering a great deal more information than our time allowed for today.
(16:20):
He's going to be taking a deeper dive into pricing, talk about different pricing models,
which transitions nicely into my next guest, Colin Fisher from OCC's pricing and margins
team.
Colin, welcome to the show.
Hey, thanks for having me.
I'm excited to be here.
Yeah, Colin, thank you.
Listen, Ken just explained pricing from an investor's perspective.
(16:42):
Let's take a look at the flip side of the coin.
Let's look behind the scenes and look at pricing from an operational perspective.
So to start, Ken and I were talking about those bid ask markets, right?
What you can buy an option for, what you can sell it for, et cetera.
But the reason that's important is because people call us or I should say people email
(17:05):
us or chat with us on our website, the investor education team.
We get a lot of questions about what is the closing price of options, XYZ, $50 strike
that expiring tomorrow, et cetera.
The reason I bring that up is because as we hear internally at OCC, no, options don't
(17:25):
have closing prices.
They have those closing bid ask markets that Ken had talked about.
So with that on the table, so to speak, we also know that OCC computes a theoretical
value for each and every option contract each and every day that the market is open.
(17:45):
And these are called mark prices that OCC uses to, among other things, margin our clearing
firms that Ken had mentioned.
So what can you tell us about that in terms of OCC mark prices?
Why does OCC create these mark prices and how do they calculate them?
How do they arrive at these values?
Yeah, so there's I think 17 different exchanges now, options exchanges, and most products
(18:12):
are dual listed.
So because of that, you may have different closing prices on different exchanges for
the same option strike for that same product.
So what OCC's role is, is to create one mark price for each strike and each product so
that you have the same price at the end of each day for an option contract.
(18:36):
So that's one of the ways, that's the main reason why we do that.
Okay, now let me ask you this.
So we do these mark prices kind of to smooth out the, you know, any pricing variances between
exchanges or something like that.
So how does, well, let me ask you this, how does OCC arrive at these?
(18:59):
I know that, you know, we've got a proprietary algorithm that we use.
What are some of the, can we talk about, even though it's proprietary, can we talk about
some of the different inputs that we use for these prices?
Yeah, so the smoothing algorithm, it is proprietary, but it's based on the Black-Scholes model.
You know, how the model works is it will take the best bid and the best ask from all 17
(19:22):
exchanges and what it does is it creates a price and a volatility at each strike.
Then once that's determined through an iterative process, it will smooth it out to make it
like a smooth volatility curve.
So instead of having like a jagged curve because maybe a bid ask is wider on one strike and
tighter on another strike, it goes through this iterative process to make a smooth curve
(19:45):
of volatility.
And so some of the prices might change a little bit.
Why we do that is to create a volatility curve which creates prices that are free of arbitrage,
satisfied put-call parity, no monotonicity issues, meaning that puts should all go down
(20:07):
from the highest strike to the lowest strike, calls should all go up or should all go, yeah,
vice versa, as you understand what I'm saying.
Right.
So as call strikes go lower, the price gets more expensive.
As put prices, I'm sorry, as put strikes go up, the put prices get more expensive.
So OCC does all of this smoothing to ensure that, for example, you know, maybe there's
(20:34):
a bid ask of, you know, something kind of out of whack, you know, maybe in, you know,
three months down the road.
So what we do is we kind of look at that and while we're cognizant of that, we don't necessarily
let that affect all of the other prices in this security.
And we do this for every single option, every single strike, every single month or expiration
(20:57):
date, and we do this every single trading day.
Every single trade.
Right.
1.5 million options.
1.5 million options.
Yeah.
So one of the reasons, you know, we do get, you know, some questions, some of them come
from you guys and people will say, "Well, how come you just don't use the midpoint of
the bid ask?"
Right.
And so when you have some of these very liquid stocks, that might work perfectly fine.
(21:18):
You could use the midpoint.
And usually you'll find that our theoretical mark prices are right in line with those midpoints
for those types of securities.
Okay.
It's the securities that are less liquid.
And by liquidity, what we're talking about, liquidity we're talking about volume, maybe
open interest for options, things like that.
(21:40):
Liquidity isn't something that we generally talk about here at OCC because it's so subjective
for so many people.
But what you're talking about are the more heavily traded securities versus securities
that aren't so heavily traded.
Yeah.
And the ones that aren't heavily traded might not have as many market makers.
Right.
And you have less people making markets in those as well.
(22:01):
And so the more market makers you have in a security, the tighter and more efficient
that market will tend to be.
Right.
Right.
So the competition kind of squeezes down those bid ask, make the tighter markets kind of
easier to figure out pricing for something like that versus a security that may not trade,
not even every day, but may not even trade every week.
(22:23):
Yes.
And for example, one of the things that people ask us at Investor Education is, well, I see
the last price for XYZ was $3, and yet you're valuing it at a dollar.
What people don't realize is that last traded price may have been three weeks ago.
Yes.
Or it could have been six months ago.
So that last traded price is kind of irrelevant.
(22:44):
But what I thought was interesting when it comes to pricing, those, that 29 point model,
some of the inputs that we look at aren't just that particular strike.
We're not looking at the $50 XYZ call expiring at three weeks.
We're looking at the $45 call.
We're looking at the $55 call.
We're looking at it expiring three months from now and six months from now.
(23:07):
And that, all of those inputs goes into that, you know, soup that gives us the price for
that XYZ $50 call expiring at three weeks.
That's correct.
That's why it's a smoothing algorithm.
Right.
So it's taking all those bids and asks, and it's trying to find a nice smooth curve.
Right.
Irrelevant if you have bid and asks that are wider on certain strikes than others within
(23:31):
that given month.
Each month is smoothed itself though.
So you do not go from smoothing a November set of contracts with your January.
It is each month separately.
And there's reasons for that, right?
You're going to have dividends that land in a certain month.
Yeah, good point.
You're going to have a plan in a given month and then you're going to have, you know, your
(23:51):
interest rates are going to be different throughout that curve, your interest rate curve.
So yeah, there's a lot of different reasons for that.
But you know, I think, you know, you brought up the last traded price thing and it's a
good question and we get it quite often.
They buy a call for $5 at $2.30.
It never, let's say it never trades again, you know, and we'll get an email saying, well,
no one ever traded it.
(24:12):
I traded it at $2.30.
How come we're not marking it at $5?
That's where I traded it.
Someone might have rallied $4 in that 30 minutes and it's a 50 delta call and that option actually
should be worth $7.
So to manage the mark to market and manage the risk of the portfolios, you really need
to recalculate all the option prices with the end of day closing price.
(24:34):
Okay.
And the end of day closing price, you're talking about the closing price of the security.
Yep, exactly.
So let me ask you this.
We got the bid ask, do we ever use prices that are marked prices ever calculated outside
of that bid ask?
From time to time.
So we have, you know, like I said, we have 1.5 million options.
(24:56):
We are within the best bid and best ask at a very, very high percentage.
We do go through a review process on PNM where if there's a number of options outside of the
bid ask that my team will look into that.
It could have to do with a dividend, a dividend forecast.
It could have been incorrect from the vendor.
(25:16):
So we look into all those different things to see why are prices slightly outside of
the MBBO and we'll look into those.
But because there's not that many, you know, my team spends two hours a night looking into
those.
Okay.
And let me ask you this, how about, does it affect the option price, the trading cutoff?
(25:40):
So for example, we've got some securities trade to 3 p.m. Chicago time, some trade to
3.15 Chicago time.
Some of those 3.15 securities on expiration, they may, those contracts may cease trading
at 3 p.m.
(26:01):
How does all that work and how does OCC take all that into account?
Yeah, that's a good question.
So a lot of the ETFs tend to trade till 3.15.
The underlying actually closes at 3 p.m.
And one of the key inputs to the smoothing algorithm is end of day best bid and ask.
So using a 3.15 bid and ask and then aligning it with a 3 o'clock close doesn't make any
(26:23):
sense.
So we worked with our exchanges, SIBO and NASDAQ, both supply us with 3 o'clock snapshots
of the bid and ask from their market makers that we use to align it with the 3 o'clock
close.
So it's a special file that comes in just for those products.
And then you can compare apples to apples instead of using a 3.15 bid ask with 3.15.
(26:46):
Oh, that makes sense.
I like that.
All right, Colin, excellent.
Thank you for that.
Let me just ask you one more question.
We were talking about bid and ask and how those inputs are used for two of the inputs
that go into figuring out what an option is worth.
What if there is no bid and ask?
(27:06):
For example, with the flex contract, which for those of you that don't know, a flex contract
is simply a customized contract that an investor can customize the terms in terms of the strike
price, expiration date, whether it settles in the morning or the afternoon, et cetera.
But because they're not publicly quoted, there is no public bid and ask.
(27:28):
So how does OCC derive prices for a flex contract?
Yeah, that's a great question.
So we use what's called interpolation or extrapolation from our standard contracts, which do have
bid asks.
So in the example of, let's say there's a flex contract that someone came up with a
150-150 strike, a strike that doesn't exist.
(27:48):
And they want to have that contract go out to February 6th.
What would happen is the smoothing algorithm will smooth its standard contracts on February
9th.
And what it will take is it will take the implied volatility in Greeks and it will use
those standard contracts to come up and try to fit that 150-150.
So what it will do is probably look very close at the 150 strike and take a lot of the characteristics
(28:12):
in the 150 strike, the standard 150 strike, and extrapolate or interpolate those to the
flex contract.
And that's all part of the smoothing process.
Okay, interesting.
Well, thank you.
Colin, really terrific news, terrific information.
We love to get information from people behind the scenes.
(28:32):
Ken and I were always kind of more of an external participant in the market, and we still pretty
much are.
But it's interesting to see how things work from operational perspectives behind the scenes.
So thank you for sharing your expertise with that.
We certainly appreciate it.
Let's shift gears for a second.
You've been in the business for a very long time.
(28:53):
You just told me earlier before we went on the air that you've been with OCC for 10 years
now.
Tell me about your history in the markets.
How did you get your start?
Yeah.
So I went to the University of Illinois, Chicago.
Just a few miles from here.
And graduated in '99.
As you guys know, that was kind of the dot-com boom.
(29:16):
I think the NASDAQ was up like 800% from '95 to 2000.
So it was kind of a good time to get into the markets.
And I knew someone at the CBOE, and he said I'd come down and clerk, so I started going
down there my sophomore year of college.
Clerked for two years.
Anytime they'd let me down there.
Work Christmas, anytime I had a break.
(29:40):
Joined the firm when I graduated and started trading pretty much right away.
I was there for eight years, then went upstairs in stream quotes for three years.
I went over to CME in stream quotes and soybeans and wheat for three more years prior to coming
to OCC.
To OCC.
Yeah.
It's funny.
Pretty much anyone in the business from the trader's side of it is a journeyman.
(30:04):
Everything that we go from firm to firm to firm to firm throughout our career, we're
still doing the same thing, just maybe wearing a different trading coat.
So yeah, interesting to see that your experience kind of aligns and matches up with ours.
So excellent, great information.
Thank you for sharing that.
Thanks for sharing that behind-the-scenes perspective.
(30:24):
And thanks to all of our listeners and supporters out there.
Lastly, I want to again remind everyone to register for Ken's upcoming pricing sessions.
And as always, please feel free to send us your questions via email at options@theocc.com
or live chat with us on our website, optionseducation.org.
(30:46):
Thanks again for joining us, everyone.
Take care and we'll be talking with you again very soon.
You've been listening to the Options Industry Council's wide world of options.
If you have questions about anything you've heard on today's show, email options@theocc.com
or visit www.optionseducation.org and chat with OIC's Infestor Education team.
(31:10):
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(31:37):
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(32:02):
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