Prediction Power of Options Markets

Peter Seed May 13th, 2007

Prediction markets always seem to be based upon stock market models where a share of stock represents an event with potential revenue, potential outcome or potential viability. But I have discovered that share-based markets, or equity markets, are not as predictive as option markets. I will tell you why.

Shares generally have some degree of volatility in price. Stock share volatility is measured as “beta”. But beta is historic. Options can predict the future because volatility is implied at a moment in time based upon the current price of an option.

The reason that options markets are more predictive is because of how options can be priced in theory using an options pricing model. One such model (Black-Scholes) won the 1997 Nobel Prize in Economics. Option pricing models “predict” what the normal distribution of future price should be using some key factors such as price of the underlying stock, time to expiration, and implied volatility.

Implied volatility is the key here. Note that implied volatility is different than historic volatility and if you understand how they are different, you will get the whole concept (check out the Option Guy’s 01/26/2006 blog about volatility at: http://optionsguy.financialblogs.com).

Implied volatility is a theoretical value that the marketplace predicts by reverse engineering the options pricing model. Yep, the result is a bell-shaped curve. Based upon the variables that make up the pricing model, the market price of an option inherently predicts what the standard deviation of price movement is for the underlying stock through the expiration date of the option. Unlike stock markets which rely upon historic calculations, options markets calculate the bell shape curve in the here and now.

This concept can be very powerful. If you have a TradeKing account (sorry, I am a co-founder and shameless promoter of TradeKing) you should check out the Probability Calculator (http://www.tradeking.com/PublicView/tools/Tools/probabilityCalculatorPUB.tmpl). This tool translates option prices into a probability of a stock either touching, or finishing above, a target price that is input as a variable by the user. I can predict, for instance, that based upon the current market for Google options on May 11, 2007, Google stock (GOOG) has a 23% chance of touching $600 a share before the end of 2007. Likewise, I can say that Google has a 39% chance of closing at the end of the year between $400 and $500 a share.

You can do the same thing based upon historical volatility, but if you are a pro option trader, you will prefer to use implied volatility.

Prediction stock markets that ignore the power of a parallel options market miss out on some valuable insights. Hit me back if you have any strong thoughts about this.