Only field that matters to markets is Psychology....Perception of Reality is the only Reality..
O Ashuji...
In markets, we often use the term recency bias to describe how we often tend to paint current understanding of events based on recent history or pricing of stocks based on recent events. The same concept has been beautifully explained in the book "Thinking Fast and Slow" - Daniel Kahenman (Chapter 12 - The Science of Availability). Ability of market participants to extrapolate recent events into the future is very natural because it gives sense of control over events. Assets gets priced accordingly, while future is invariably very different and hence asset prices in future is very different. I will quote part of text from the chapter "The Science of Availability" and then understand how same can be applied to option pricing.
Markets and "The Science Of Availability"
"We defined the availability heuristic as the process of judging frequency by the - ease with which instances come to mind." - "Thinking Fast and Slow" - Daniel Kahenman (Chapter 12 - The Science of Availability)
Similarly in markets recent price performance will be extrapolated and in most cases results will be very different. Few examples from the book "Thinking Fast and Slow" on "The Science of Availability"
1) A salient event that attracts your attention will be easily retrieved from memory. Divorces among Hollywood celebrities and sex scandals among politicians attract much more attention, and instances will come easily to mind. You are therefore likely to exaggerate the frequency of both Hollywood divorces and political sex scandals.
2) A dramatic event temporarily increases the availability of its category. A plane crash that attracts media coverage will temporarily alter you feelings about the safety of flying. Accidents are on your mind, for a while, after you see a car burning at the side of the road, and the world is for a while a more dangerous place.
3) Personal experiences, pictures, and vivid examples are more available than incidents that happened to others, ore mere words, or statistics. A judicial error that affects you will undermine your faith in the justice system more than a similar incident you read about in a newspaper.
Similar examples one can be applied to markets and same gets priced into options accordingly.
Options Value (primarily through higher implied volatility) will tend to rise going into major economic/monetary events. Market participants tend to exaggerate expected market movement. Actual market movement post event in most cases is very muted compared to implied by option prices. Apply this to Obama re-election event, Fed Meetings, RBI Meetings, Infosys Results, etc. Most of the time option prices will exaggerate expected price movement. Implied volatility plays very crucial role in option pricing.
In past, I have written extensively about compression of prices and how the same affects option pricing.
1) Why Options are best way to play "Central Banks"
dominated markets.....(29 May 2013)
2) August 2013....Setting up for BIG MOVE in Equity
Markets...!! (23 July 2013)
3) Market Compression Reaches Extreme !!! (26 December 2012)
4) Is Nifty's Implied Volatility Under Pricing Actual Volatility.....? (4 July 2013)
Options can become very cheap due to...
1) trending markets
2) perceived risk is smaller than actual risk (when major events are out of way)
3) market moves are very subdued (small ranges, lower volatility etc)
Very Favorable Entry Point in Buying Straddle or Puts for January 2014 for Nifty...
Indian Market (Nifty) Internals still fails to point healthy market (will try to discuss in some other blog)..Though entry point is not as good as in late July 2013 (Pls refer to blog dated 23 July 2013), but still very favorable.
Subdued December (and major event out of way - RBI and Fed Taper) is getting priced into option markets through sharp fall in IVs. Actual risk is higher when perceived risk falls.
Large number of trading days and lower IVs for Jan 2014 provides very favorable entry point for option buyers (more so put buyers)
Really many thanks for this awesome helpful blog. I love getting impressive information….
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