The price of options is considered a proxy for the expected price moves of stocks over time due to several factors:
1. Implied Volatility: Options pricing incorporates implied volatility, which represents the market's expectation of future stock price volatility. When investors anticipate higher price swings in the underlying stock, the implied volatility, and subsequently, the option prices tend to increase. Thus, higher option prices indicate an expectation of larger price moves in the stock.
2. Option Delta: Delta measures the sensitivity of an option's price to changes in the underlying stock price. Delta values range between 0 and 1 for call options (0 to -1 for put options). When delta is closer to 1 (or -1 for puts), it suggests that the option price will move more closely in line with the stock price. Therefore, higher delta values in options imply that the market expects significant price moves in the stock.
3. Option Pricing Models: Option pricing models, such as the Black-Scholes model, consider various factors like stock price, strike price, time to expiration, risk-free interest rate, and volatility to estimate the fair value of an option. These models provide a framework for pricing options based on the market's expectation of stock price moves. When the market expects higher price volatility, the option pricing models output higher option prices.
4. Market Sentiment: The supply and demand dynamics of options in the market can also reflect the overall sentiment and expectations of investors. When investors anticipate significant price moves, there is often increased demand for options as they offer potential leveraged returns. This heightened demand can drive up option prices, indicating the market's expectation of larger price moves in the underlying stock.
However, it's important to note that option prices are not a direct predictor of stock price moves. They represent market expectations and can be influenced by various factors, including investor sentiment, market conditions, and external events. Additionally, options also include other components such as time value and risk premium, which contribute to their pricing beyond the expected price moves of the underlying stock although those components are part of the option investors assessment of the price move over time.
The price of options can serve as a proxy for the expected price moves of stocks due to the nature of options contracts and the factors that influence their pricing. Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset (such as stocks) at a predetermined price within a specific time period. The price of an option is influenced by several key factors, including the current price of the underlying stock, the strike price (the price at which the option can be exercised), the time to expiration, the level of market volatility, and the prevailing interest rates. Implied volatility is a crucial factor affecting the price of options. It represents the market's expectation of the stock's future volatility over the life of the option contract. When market participants anticipate greater price swings in a stock, the implied volatility increases, leading to higher option prices. Therefore, by analyzing the price of options, particularly the implied volatility, QuantDirection can gain insights into the market's expectations for future price movements of the underlying stock. Higher implied volatility suggests that market participants expect larger price swings in the stock, while lower implied volatility indicates expectations of smaller price movements. We can then use this as an underlying framework to gauge how particular price conditions do relative to the expected move for each unique time period. Additionally, the pricing of options incorporates market sentiment and expectations, which can reflect the overall bullishness or bearishness toward a stock. For example, if the price of call options (which provide the right to buy the stock) is relatively high compared to put options (which allow the sale of the stock), it suggests a bullish sentiment and expectations of upward price moves. This is another reason why QuantDirection uses options pricing as a baseline framework so that we can eliminate changes in sentiment as a factor in driving changes in price behavior. Essentially sentiment is already baked into the pricing and therefore we just need to measure how price behaved relative to the expected move. However, it's important to note that options prices are not infallible predictors of future stock price movements. They are influenced by various factors, including market supply and demand dynamics, speculative activity, and unforeseen events. Therefore, while options pricing can provide valuable insights, it is still essential to conduct thorough analysis and consider other relevant factors when making investment decisions.