Veteran options trader Dan Passarelli explains a new methodology for option trading and valuation, paying special attention to how more accurate pricing can drive profit. In straightforward language and making use of charts and examples, Passarelli explains how to use the greeks--the five factors that influence an option’s price—to trade more effectively. Understanding the greeks enables traders to quantify risk, trade components of price such as volatility, and, most important, profit in every kind of market: up, down, sideways, and volatile.

Dan Passarelli began his career as a floor trader at the Chicago Board Options Exchange (CBOE) trading equity options. He currently provides options education to retail and institutional traders at a premier brokerage firm.  Passarelli was an instructor at the Options Institute, which is the educational arm of the CBOE.  He also worked with the Options Industry Council (OIC), educating retail traders via podcasts, webcasts, live seminars, and has written numerous published articles.

Chapter 2
Greek Philosophy

In late 2006, just in time for the Christmas shopping season, Sony

released the PlayStation 3 (PS3). It was such a hot item that people

stood in line for hours—and in some cases days—to be among the

fi rst to own one. The problem was that many stores couldn’t stock

enough of the computer entertainment systems to meet the demand

on the day they were released. To keep the peace, some stores gave

out tickets that gave the holders the right to buy a game system. For

some of the more entrepreneurial PS3 enthusiasts, this was an op-

portunity. Some gamers sold their right to buy the PS3. The tickets

themselves had value. What gave these tickets representing the

right to buy the PlayStation 3 value? The same two things that give

everything value: supply and demand.

Price vs. Value: How Traders Use Option-Pricing Models

Like the PS3 ticket, the right to buy or sell an underlying security—

that is, an option—has value because of supply and demand. There

are several variables in an option contract, however, that can influ-

ence a trader’s willingness to demand or supply an option at a given

price. For example, a trader would rather own—that is, there would

be higher demand for—an option that has more time until expira-

tion than a shorter-dated option, all else held constant. And a trader

would rather own a call with a lower strike than a higher strike, all

else kept constant, because it represents the right to buy at a lower

price.

Several elements contribute to the value of an option. It took

academics many years to figure out exactly what those elements are.

Fischer Black and Myron Scholes together pioneered research in

this area at the University of Chicago. Ultimately, their work led to

a Nobel Prize for Myron Scholes. Fischer Black died before he could

be honored.

In 1973, Black and Scholes published a paper, called “The Pric-

ing of Options and Corporate Liabilities” in the Journal of Political

Economy, that introduced the Black-Scholes option-pricing model

to the world. The Black-Scholes model values European call op-

tions on nondividend-paying stocks. Here, for the first time, was a

widely accepted model illustrating what goes into the pricing of an

option. Option prices were no longer wild guesswork. They could

now be rationalized. Soon additional models and alterations to