How Do Options Make Predictions?

[MAESTRO]

Quote from ML_QUANT:

A very interesting study indeed.
Meanwhile, do you agree that 100% of all physical nature can indeed have a mathematical solution(even if not known or discovered by human yet)?
On the other hand does the human mind fit within that physical nature with a 100 B. neurons that each have 2500 branches if you will?
I believe not, the human mind is not part of the physical nature hence the randomness and the inability to mathematically define it.
However there is indeed many patterns to their collective behavior contrary to their singular and solo actions and reactions which explains the school of fish or the flock of birds mindless following of the herd... I kicked off the same concept on the TS forum a couple of 2 years ago and no one caught up to it then.
The advance of TA is impressive and makes the scientists predictions of kids in the near future making Millions of $ daily at their home quite believable.

Back to the topic at hand, during the 86 era, when the INX was the only electronically instrument traded(I think), the attraction of the options was that they over reacted to any event of the underlying price and presented huge scalping opportunities which seems to have dissipated by now for obvious reasons and thus my silly question, where is the edge of trading options nowadays Vs. the underlying which is cheaper and faster to trade?

How about this? http://www.pnas.org/content/102/6/2254.full

I do not believe that we are any different from ants when it comes to collective behavior patterns.

 

[MAESTRO]

Quote from shortie:

OP asks an innocent question and MAESTRO spills the beans about his super secret option strategy.

hilarious

but OP never gets his question answered as far as I could tell

As usual, you have missed the point. As the matter of fact OP got the answer or at least an idea of a direction.

 

[MAESTRO]

Quote from ChocolateGirl:

That was my feeling too. After 100 responses, beside that some people can make money using the predictive power of options, what have we learnt?

Can someone summarize it? Thanks...

We have learned that a very few people here on ET could intelligently discuss options and their properties. Even less of us could share ideas of their predictive power. The purpose of this discussion is to encourage people to learn more about hidden characteristics of options and their collective behavior so they could appreciate the beauty and complexity of option formations. And who knows, may be using these ideas discussed in this thread some of you might discover the "predictive power of options" and make use of it in their trading. For those who are looking for handouts and simplistic answers I don't donate on Fridays!

 

[shortie]

Quote from kjb1891:

I've seen it numerous times where someone will something along the lines of "options are predicting an X% move for XYZ stock".

How would you go about determining that? Do you look at specific signs from volume, open interest, IV, B-A spread?

back to OP question: maybe you need to look at how VIX is built (search wiki for VIX). VIX is a mix of options converted to show expected movement in S&P.

"The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis. For example, if the VIX is at 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the S&P 500's 30-day return will be less than 4.33% (up or down)."

 

[KINGOFSHORTS]

I spend hours watching equities/options and lots of data. Yes you do see very interesting patterns emerging.


Lots of interesting stuff. Anyhow I am a math/science geek and I like Chaos theory,fractals etc..

But I make my money on the other end

 

[Random.Capital]

Quote from ML_QUANT:

do you agree that 100% of all physical nature can indeed have a mathematical solution(even if not known or discovered by human yet)?

Godel already answered that for us: No.

 

[murray t turtle]

Quote from dmo:/Random Capital

This sounds very logical but - and this is just my experience - this kind of linear logic will get you nowhere in the markets. It just doesn't work that way.

Maestro's "poetic" approach - where money and human herds move in ways similar to a school of startled minnows - is a more fruitful and accurate way of looking at it IMHO. I don't know what his strategy is but in general the way he talks about market behavior rings true.

===================

I started to write something like you did,DMO;
agree.

Random nickname Capital, did start out his theory, with the perhaps carefully chosen words ''Imagine the mythical smart money. '' His use of the word mythical perhaps was not random.

What else did we learn??
Well speaking of fish, fish school ,to play on words,;
Mr Daryl Guppy[real name] said do not confuse high probability
with infallibility.

I also would not confuse prediction with probability or high probability also ;
big , real practical difference.


Maestro had a good but funny warning on CNBC,LOL


murray

 

[ML_QUANT]

Quote from Random.Capital:

Godel already answered that for us: No.

You are confusing "Natural number" with "Nature"!

Other than sharing "Natu" they have nothing in common.

 

[ML_QUANT]

Quote from shortie:

back to OP question: maybe you need to look at how VIX is built (search wiki for VIX). VIX is a mix of options converted to show expected movement in S&P.

"The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis. For example, if the VIX is at 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the S&P 500's 30-day return will be less than 4.33% (up or down)."

+1 shortie, informative post.

 

[black diamond]

Quote from dmo:

Right, lognormal prices. That's what I meant.

The skew in stock market index options doesn't change much, but the skew in other options - such as options on crude - does change a lot. Sometimes the OTM calls trade way higher than the ATMs while the OTM puts trade at the same IV as the ATMs. Sometimes it's the puts that are expensive and the calls that are cheap.

According to your theory, more expensive OTM puts would mean a higher probability of a move down. My observation is that the opposite is true. More expensive puts mean excessive bearish sentiment, which is bullish.

I don't disagree with you, I am probably just not being clear. It is not my theory, just a mechanical relationship that causes a skew when the shape of the models' distribution is different than the shape of the market's perceived distribution. If the market thinks there is say a 30% chance of a 10% loss in the underlying over the next month and a 15% chance of a 10% gain, then there has to be a vol skew because one implied vol can't price both beliefs in Black-Scholes.

So I guess I am saying that the smirk in equity index vol means the market thinks there is a higher probability of a big decline than a big gain. On average that is right historically so there should be a smirk, at least most of the time, and more demand for downside protection makes sense if you can't time the market.

I think what you are saying is that when the smirk gets more extreme than normal the market is wrong in its prediction and there is actually a smaller chance of a big drop than usual and a higher baseline expected return, which makes sense and doesn't contradict what I was trying to say. Are you observing this in equities or just in crude?