This article was originally published on ETFTrends.com.
By Kayla Matthews
New research indicates there could be a significant difference between a stock option's closing price and what an investor pays for it. Before going into what the study's authors found, here's some context to make the conclusions easier to digest.
Options vs. Stocks
When people start researching the stock market and how they might invest, they often learn about stocks and stock options. Although their names are similar, those two investments are different.
When someone purchases a stock, they own a portion of the respective company. Most people who buy stocks do so because they believe the business will become more valuable over time. Conversely, stock options are derivatives of stocks. Their value shifts as the underlying stock linked to them does.
People .who deal with stock options typically aren't individuals who intend to hold onto them for long periods. They're traders who are betting on the value moving up or down, and they believe they have advance knowledge of those changes that will benefit them.
How Do Options Work?
A stock option is like a contract between two investors. There are also two main types : call options and put options. With call options, the investor who wants to buy enters into an agreement to get the stocks at an agreed-upon value — the strike price. However, the purchase must happen on or before a specified expiration date.
The selling investor takes a risk by committing to deliver the stock by the expiration date. The buyer compensates the seller for that risk by paying a premium.
A put option affords an investor the right to sell shares of stock at a strike price before the expiration date happens. In that case, the other investor involved assumes the risk of having to buy that option at the strike price while keeping the expiration date in mind.
Before committing to stock options, investors try to calculate their returns on those options. In other words, they gauge the anticipated profit or loss that happens after their investment.
Using the Greeks to Minimize Risk
Participating in the stock market is all about maximizing rewards by keeping risk to a minimum. Stock option traders do that with a series of Greek letters collectively known as "the Greeks."
Here are the main Greeks applicable to stock options:
- Delta: A representation of what happens to an option's price when the underlying stock's value goes up or down
- Gamma: The rate of change for the delta
- Theta: A description of how a single day affects an option's value
- Vega: A measurement of how a change in estimated volatility affects an option's price
What Did the Researchers Conclude?
The team examined equity and index options for their study. Equity options are those described above that give people the right to buy or sell according to specified terms. Index options work similarly, but they deliver the asset in cash. An index option is a number that quantifies the value of a portion of the stock market.
The researchers showed that, at the end of a trading day, both equity and index options quoted bid-ask midpoints. However, those did not accurately reflect a day's trading prices. A bid price is the highest-priced buy order currently on the market, and the ask price is either the lowest-priced sell order on the market presently or the lowest price at which someone will sell.
The difference between those values is often called the buy-ask spread. The midpoint is the average between the lowest ask and the highest bid.
The researchers' work looked at delta-hedged return options. Delta hedging is a strategy investors use to minimize the risk that occurs due to the movements of the underlying stocks. They showed that using midpoint quotes for delta-hedged options resulted in computations that were up to 1% higher per day than any other midpoint quotes used during a trading period.
Moreover, the researchers explained that introducing nighttime trading for European stock options — those which investors may only exercise on the expiration date — enables overnight inventory hedging. It also allows for more flexible liquidity provision when the stock market opens for daytime trading.
A New Perspective
In their full research paper, the team explained that delta-hedged returns have an upward bias, and they do not represent the gains or losses experienced by an average investor. They also confirmed that certain times of the day are better, depending on if an investor wants to buy or sell options.
The authors confirmed that more research would help expand their findings. Even in these early stages of the work, the conclusions may be eye-opening to investors.
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