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How to Price LinkedIN Options

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LNKD options are listed today, which is going to be a boon for all those looking to short the stock but can't find shares to short. I think the short bias may be a little oversubscribed, and we've seen how that's worked out over the past 18 months.

Aside from the demand for these options, it's going to be interesting to see how they are priced.

Valuing an Option

If you've taken any sort of derivatives class at University, this is where the math they teach you comes into play. Yes, those terrible times where they had you solve a partial differential equation for a formula that a computer could spit out in a millisecond finally comes in useful.

An option value is comprised of two parts: intrinsic and extrinsic. The intrinsic value is how the current option relates to the price of the stock. It is effectively the difference between the strike price and the stock price and whether it is advantageous to exercise the option at expiration.

Risk Premium

The other part of the value is the extrinsic value, which is also known as the risk premium. Premium can be divided into two parts (there's other components but these matter the most); time premium and volatility premium. The former is how the option relates to its expiration date, and the latter is how the options market thinks the stock will move.

The extrinsic value can also be used to measure the supply and demand of the options. If you think the demand for options is too high, you can be a net option seller, and vice versa.

So far so good, right? Well, what we can do here is use the extrinsic value to figure out what the options market is expecting in terms of movement-- this is known as the "implied volatility" in the option. How the market views volatility and how you view volatility is how you are able to make super-smart option trades.

Is this still making no sense? Go pick up OptionFu. You'll thank me.

What If There's No Data?

This is where it gets tricky, and its sort of a chicken-egg problem. How do you price an option if there's no available market to measure supply and demand? I'm pretty sure that the derivatives desks have fancy pricing mechanisms, but I'm going to use some quick and dirty methods to get a rough idea of where they should be trading in the morning.

3 Ways to Value LNKD Options

View the Current Volatility. The stock's been trading for only a few days, but we can see what has been going on with respect to current volatility in the price. Remember that often the implied volatility in options will keep a higher bid relative to historical volatility.

The current 5-day HV reading is about 90%. So it's very possible to see triple digit implied volatility for a while.

Run Comps. It's useful to see how comparable stocks are trading and what their option boards look like. There's no new-big-social-media names like Facebook or Twitter on the market, but we can look at highly volatilie china internet names as there's been a lot of speculative  money in this space with high volatility. We can also look at more "mature" names to get an idea where vol may be headed in 6-9 months after a few earnings and it cools off.  Here's some names with their current at-the-money put  implied volatility:

[edit] RENN is another name in that recent IPO spec space, and the put implied vol is running at 101%. So i'd say that a high 80s estimate would be a good starting off point.

Price in Liquidity. The shorts are salivating to get on this "disaster" of a stock, which may be a contrarian bet. Nevertheless, we've seen much of the share liquidity already get snapped up and are short already, making this name very difficult to borrow. There may be a high demand for options going into the pricing, and we could see a lot of bearish synthetics deployed. If you're a market maker you're going to have to short stock to balance your books, which is going to be a huge pain. So for the time being we'll probably see a higher price for the options to reduce overall demand, and a pretty wide bid-ask spread so the market makers can stay sane.

 

All in all, I would not be surprised at all with triple digit volatility until the name cools off a bit. In terms of plays, if you're leaning short, you may want to consider bear call spreads to reduce your risk and sell the fat premium that will be available. Other short premium positions such as condors and strangle sales should also be considered here.

[edit2] And the market's up, we're seeing implieds in mid 80s, to the triple digits on the extremes, and the put implied is higher, much higher than the calls right now.

 

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/