Paul, Part of the reason for chucking Black-Scholes is that it is an silly model than has no relationship to the real options markets. It does not take into account things like discontinuous pricing, the forward looking nature of the beta calculation, sudden changes in the risk free rate and the dangers of too many players using the same models or slight variations of it. I think Myron Sholes, by helping take down Long Term Capital, finally proved all of the points that got me a "Pass" by a whisker grade in Speculative Markets at Wharton. <G> And I only got that Pass because the professor, who admitted that he could never do well with his own investments and helped mangle Penn's previously mighty endowment, didn't want to see me kicked out of the doctoral program when I had high grades in all my other courses.
The second reason I throw out the aptly named B-S is that it has nothing to do with the future movement of the underlying issue. One of the points on which I have such an argument with beta calculations is the assumption that all volatility is risk. Volatility the right direction is not risk, it is opportunity.
A third reason why I ignore it is that everyone on the floor who is making markets for options have the prices in their little palm computers. Bid is usually set, on active options, just below fair value, offer just above it. If you ever buy an option, put or call, below B-S fair value, you are almost certain to have bought a turkey. And if you ever sell one above fair value, you are likely to see big time movement in that stock. The only reason MMs set outside the fair value ranges is because they are eager to go the other way. And these guys have little capital and it is all borrowed, so they have to feel they have inside info if they give you a "good" deal. <G>
The other point is, I generally buy out of the money options, as I am swinging for homeruns in the 90/10 portfolio. The out of the money options are always priced too high to buy. In fact, they are often priced above fair value even on the bid side. And I have friends who have destroyed portfolios by selling "overvalued", far out of the money options, short. One particular buddy, a brilliant Ph.d. from the creme de la creme Economics dept. in the world, has taken down two institutions with this strategy. It works great for a long time and he has infinitely more winners than losers. But when he hits a clunker, it is a doozy. When he hits a winner, it is, at best, a half a point. Making 1/8s, 1/4s, and 1/2s several times does not make up for one 20 point killer.
Essentially, I look at a stock that could move in large steps. Presstek from $200 to $50, MU from $95 to $17, Merrill from par to $50, Citicorp from $182 to $88 are examples of ones that worked well. In every case, I bought puts too early and suffered a bit. With Presstek, it was agony for months. But the payoff, Paul, the payoff is soooooo good. Again, in every case, B-S would have told me I was overpaying for these options. And my reply would have been that B-S is bs.
I think 99% of your effort has to be in stock direction. You then employ options and a betting discipline, 90/10 is mine, but it is hardly the only one, because Citicorp occasionally runs from $130 to $182 before sanity is restored to the market place. And, sometimes you will be wrong. And sometimes you will be right but not right enough to make up for the premium. But the times you hit a homerun more than makes up for those mini losses.
I don't have access to Skeeter's portfolio details. In fact, since his broker lived up to the name of broker, I don't think Skeets does either. But I know he suffered losses on MU and a couple of other stocks last year. However, my guess is that he made up for a lot of that with just one option stock, Chase Manhattan. And, by using 90/10, he was able to reload and play another day. Whether or not some model says he overpaid for CMB puts probably never entered his head and I think it probably doesn't belong in the decision making process.
MB |
