Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.
As we prepare to enter 2015, financial pundits aplenty will be giving you their forecasts for the upcoming year. People have a tendency to overestimate their confidence when working with ambiguity or uncertainty.
Rather than anchor myself to any pundit, I want to look at what the market is expressing through options. On Friday, December 27, 2014, the SPX closed at 2088.77. Looking at the SPX December 2015 Options (those that expire on December 18, 2015) and using thinkorswim’s platform for options, I note the following:
- about a 90 percent probability that SPX closes above 1400;
- about a 90 percent probability that SPX closes below 2400.
Alternatively, we can state that there is an 80 percent (equals 100 minus 10 minus 10) probability that SPX is between 1400 and 2400. We note the skew to the downside.
Now, let’s look at 80%:
- about a 80 percent probability that SPX closes above 1650;
- about a 80 percent probability that SPX closes below 2300.
Alternatively, we can state that there is a 60% (equals 100 minus 20 minus 20) probability that SPX is between 1650 and 2300. Note again the skew to the downside.
Incidentally, the approximate volatility across different strikes for next December’s SPX options is about 20.4%.
Looking at the first series of numbers, we note that low value of 1400 is about 67 percent of today’s value and the high value of 2400 is about 15 percent greater than today’s value. Looking at the next series of numbers, that low value of 1650 is about 79 percent of today’s value and the high value of 2300 is about 10 percent greater than today’s value. The downward skew is clearly evident.
If these numbers seem way out there—way too far to even be considered—one can always sell the puts or calls and pocket the “risk-free” money. Me, nothing surprises me anymore, so I don’t consider any potential profits to be risk-free. Put differently, there is no “risk-free” money. While these values might seem far away from today’s values, there can always be surprises that warrant lower or higher values.
How many of us predicted some of today’s geopolitical concerns or the plummet in oil prices? The unknown unknowns can and will surprise us.
How accurate or reliable are these option generated percentages? These percentages are simply based on an option’s pricing model. As prices move throughout the year, the values will change. At present, however, these values represent the market’s view. That view will change. If you disagree, you can always take the other side. But I do find looking at an option pricing model’s values helpful because it reminds me how much volatility and uncertainty exists. It’s too easy to get lulled into thinking into a pessimistic or rosy forecast.
So when you hear or read about some pundit providing a rosy forecast, think back to our exercise. How many pundits are expressing that the market could have a significant retracement? My guess is that most pundits are going to express an opinion of a market rise of somewhere between five and 10%, largely because we’ve enjoyed two strong years. Yet, from the options model’s values we noted the skew to the downside.
The key point from this discussion is to keep an open mind to next year’s potential outcomes.