NOTE: This document is a modified description of our legacy Options Level 1 Fair Value to Market Value Hedge Ratio solution still featured with Level 2's Price Analyzer charts. It is an alternative method of determining an option pair's forward value. However, the recomended method to forward value an option is implied pricing using implied volatility's in combination with sticky decay processes that are the central feature of Options Level 2's Implied Pricing Model. The recommended method to model forward spot values is to send market straddles from the CBOE Parser View to Options Level 2's Implied Pricing Model. The American and European Models (closed form) best forcast near the money options from 2 to 2 1/2 weeks out from the market date. Deep position prices can only be serviced by the American and European Models. The 3rd week out from the market chain's date, the convergence model delivers the most reliable forecast. After 4 weeks, near the moneys spots are better serviced by Level 2's [sticky] decay (theta/delta). However, you may find utility in the hedge ratio approximations. They are suprisingly close to backtested outcomes, but they are not the generally accepted method to value options.

Development History

Option Level 1 version 109b introduced features that marked the stock to strike and market to fair value ratios for parsed CBOE chains. 109b also added inputs to the pricing surface legends to manually enter a M:F, or Market to Fair Value ratio, to compute CPM (the predicted ROI). Version 109c completely automated the correlation through a “pick list” that automatically inserted the correlated M:F value and CPM computation. CPM is M:F x Fair Value x 100 less Cost (Ask) x 100. A negative CPM states the portion of premium that would be lost to close. A positive CPM is the net profit, or closing price less the opening cost.

Fair value, by itself, is not a useable indicator of an option's future potential for market returns. Option Level 1 sets itself apart from the field of other chain pricers, in one regard, by approximating a reliable indication of the future market to close the option. Option Level 1's other features, such as it's robust crisp interface, 75 3-Dimensional Black Scholes and BSA 2002 time to price to value pricing charts, quantity, accuracy and ease of data presentations, as well being manufactured with a true programming language, are other considerations.

Disclaimer

Options Level 1 does not actually "predict" a market value. The market cannot be predicted. Instead, Level 1 makes an informed approximation on the future prospects for a given option based on current market metrics expressed by other options in the chain.

About the Case Study

A January 14 2009 CBOE Chain was used to test the reliability of the predicted ROI against actual ROI for matched strikes and expiration presented in a March 9 2009 CBOE Chain for MSFT options. Carrying and dividend costs were held at zero. The same historical volatility, as published by CBOE, was used for both chains. The January 14 predictions for March 9 were revealed through interacting with the January 14 pricing surface by selecting the March 10 band for a 15.18$ stock price. The result was compared to a March 10 CBOE chain at the 15.15$ (actual) closing price for MSFT stock. The predicted ROI was compared to the actual ROI for a series of strikes for a July 2009 expiration. The “pick feature” was set to full automatic. The study did not shop the pick list for confirmation. The study allowed Options Level 1 make the "predictions" without intervention.

Conclusions

For stocks pricing in the 20$ range and with a 50 day out pricing horizon this method may be safe enough to make a judgement about a narrow strike band near the stock price. Correlation worked best with stocks that exprienced a decline during the initial part of the 50 day window and then trended higher. It would not be reccomendable to use this method for "expensive" stocks or further out pricing horizons. We are looking into Delta and Theta corrected pricing that hold promise for the same positive correlations exhibited in this study and will provide case studies for both the M:F and Delta/Theta corrections as they are completed.

While we wait to complete testing of our Delta and Theta correction method, we can offer some insight to measure likely close to sell ROI for options outside the case study. A liberal approximation would be to split the difference between fair value and current markup. For example, should the markup be 140%, substitute 120% for the M:F ratio. For conservative assessments, set the M:F ratio between 102% and 110%.

Results

Options Level 1 “predicted” a closing ROI for 4 MSFT strikes with Jul 2009 expirations for a March 10, 2009 close. The sell to close ROI, or return on investment, is measured as the difference of what the option was purchased at on January 14 and what it could have sold to close at on March 9. The predicted outcomes were then compared with actual March 10 2009 market positions. The results are summarized as follows:

The Jan 14 predicted Mar 9 15$ CALL ROI was: -325$. The actual CALL ROI was: –334$. Variance: 2.9%
The Jan 14 predicted Mar 9 15$ PUT ROI was: 52$. The actual PUT ROI was: 59$. Variance: 12%

The Jan 14 predicted Mar 9 17$ CALL ROI was: -275$. The actual CALL ROI was: -277$. Variance 1.0%
The Jan 14 predicted Mar 9 17$ PUT ROI was: 103$. The actual PUT ROI was $112$. Variance 8.2%

The Jan 14 predicted Mar 9 19$ CALL ROI was: -214$. The actual CALL ROI was: -220$. Variance 3.0%
The Jan 14 predicted Mar 9 19$ PUT ROI was: 134$. The actual PUT ROI was: 168$. Variance 20%

The Jan 14 predicted Mar 9 21$ CALL ROI was: -157$. The actual CALL ROI was: -160$. Variance 1.0%
The Jan 14 predicted Mar 9 21$ PUT ROI was: 204$. The actual PUT ROI was: 225$. Variance 8.7%

Overall, the predictions were almost spot on. The test was limited to a small sample at a specific expiration. It’s not scientific. However, the results are what they are: a mathematical result that can be replicated.

Here’s a detailed snag of the results:

In addition, a bid approximation based on the assessed M:F conversion ratio and spot fair value can be rendered by hovering the mouse pointer over the "CALL" or "PUT" leg labels. The image below prices the call bid about one month out for a March 10 pricing model of 15$ July Call (to Apr 17 at a 17.28$ stock price) with the current stock, or model price at 16.48$.