How efficient is the listed stock options market?

Question

And how is it possible that some options close at extremely low or negative implied volatilities? (This question doesn't really belong to the "investing" category...)

Okay, I still haven't understood the mathematical model completely. But it's possible for the implied volatility to go to zero, or close consistently below average. I noticed a few in-the-money options about to expire which could be bought and exercised at a net gain, i.e. with intrinsic value slightly larger than the premium. Is this weird? Some kind of trick? Why can't the option be bought and then sold at a fairer imp. volatility?

Answer 1

Between the Bid/Ask spread, commissions, and slippage, it eats up those small differences you're talking about.

Also, the quotes you are seeing are probably "Last Trade," which could have been hours or days ago. And unfortunately, some floor traders don't update their screens often enough, and when you go and try to purchase at the quoted price, the price then changes.

There are full-time programs that monitor these small differences, and when they get too wide, automatically take advantage of them. It is called arbitrage.

This is a very professional and advanced game you are looking at, with pitfalls and unknowns the novice can't even imagine. It is a game for those with deep pockets, where pennies add up to significant amounts. It is a game for those well-equipped complete with option evaluation programs and a staff to manage it and watch it full time. And finally, it is a game where years and years of superior knowledge and experience always trumps the novice. It is very precise and specific, with no room for such psychological errors as hope and wishing, like in the stock market, where you Buy and everything makes money, regardless of your skill level.

If it is leverage you want, try Forex.

Answer 2

There's no such thing as negative implied volatility. That would be the equivalent of buying an option AND collecting the premium. Obviously, that doesn't happen.

I think you're figuring implied volatility incorrectly. What specific option are you talking about and I can answer fully.

There are a couple of things to remember:

First, don't forget the time value of money. For example, option market makers are happy to sell deep in the money options at intrinsic because they'll collect interest on the premium received for selling the options.

Second, if an option doesn't trade in a day then the closing price you see is actually the previous days closing price. This can throw your calculations WAY off.

Third, some options can't be exercised until the day of expiration. These "European" style options are the ones most likely to exhibit this because the option seller knows he's going to be able to earn interest on the premium every day until expiration.

If you'll cite a specific example I can better explain the issue.

Answer 3

Some may close low, but rarely will they go negative. Best way to tell this is to look at the volatility chart vs. its history.

The efficiency will be dependent on the volume traded and volatility. Some are great. Others like the OOO or some thinly traded options have pretty high spreads.

Hope that helps!