Stock Market Wizards
John Bender: Questioning The Obvious
John Bender believes that the option pricing theory developed by Nobel Prize winner Black Scholes Merton and also used by traders worldwide is fundamentally flawed.
From 1989 to 1995, he realized an average compounded annual return of 187%, while he lost only in three quarters. The worst decline being that of 11%.
He follows a principle: Don't accept anything instead question everything. The principle is relevant not only in trading but in all professions.
One of the basic principles of option theory is that the stock prices on a future date follow a normal distribution. Many traders have improvised this model by adjusting the curve and making its tails fatter because the rare events were much more common than predicted. However, Bender has further gone to question the very premise of using a normal curve as the starting point for describing prices. He has also questioned the usage of a single model to describe the price behaviour of different markets and stocks. By ditching the concept that price movements are random and are normally distributed, he was able to derive much more accurate option pricing models.
Ideally, options should be used to trade when the trader's expectations differ from the theoretical assumptions. For example, if a trader thinks a stock is going to witness a rapid price rise before the option expiration date, then obviously buying the out of the money option might be a better trade than buying the stock itself. This is because OTM call options are relatively cheap. After all, they will have value during expiry only if the stock price rises sharply.
He cites another example to explain further. Assume, there is an upcoming event that can cause the stock price to rise or decline. The chances of the stock price going in both directions are equal. If it is bullish, then the chances of a high price rise are much more than a moderate price rise. However, the standard option pricing model assumes the opposite. It assumes that a moderate price rise is more likely than a high price rise. Hence, if the assumption made by you is correct then it is possible to create an option strategy that will keep the odds in your favour. For e.g., you may sell the ATM call options and use the premium received to buy a larger quantity of OTM call options. If the price declines, then you will tend to break even. If the price rises a little, you will lose moderately and if the price rises sharply, then you will win big. This strategy is known as Call Ratio Back Spread.
He believes that the key to using options effectively is to chalk out your expectations of the probabilities of a stock moving to different price levels. If these expectations differ from the assumptions of standard pricing models, that means there are favourable option bets available. This holds true only if your expectation tends to be more accurate than random guessing.