Options trading: how millions earn (part 1)

Recently was circulated information that BlackRock Inc -3.43%. (one of the largest investment companies in the world and the largest in the world in terms of assets under management) awaits a large pound movement. The most interesting thing is that company analysts can’t say for sure, whether it will be the growth of the pound or its fall. But they know for sure that a big movement is coming.
The question is: how to make money, having such information?
Direct buy/sell transactions can lead to big losses, if you don’t guess with the direction. Therefore, instead of the usual operations in the spot market, you can use derivative markets, and such a financial derivative instrument as options.
We will not give a lecture on what options are, about their types and how they work.
Instead, here is a fragment of the book by Michael Lewis "The Big Short”, which very brightly and colorfully describes how potion trading can make millions.


"What happened next led them, almost by accident, to the unusual approach to financial markets that would soon make them rich. In the six months following the news of its troubles with the Federal Reserve and the Office of Thrift Supervision, Capital One's stock traded in a narrow band around $30 a share. That stability obviously masked a deep uncertainty. Thirty dollars a share was clearly not the «right» price for Capital One. The company was either a fraud, in which case the stock was probably worth zero, or the company was as honest as it appeared to Charlie and Jamie, in which case the stock was worth around $60 a share. Jamie Mai had just read You Can Be a Stock Market Genius, the book by Joel Greenblatt, the same fellow who had staked Mike Burry to his hedge fund. […]

There were times, Greenblatt explained, when it made more sense to buy options on a stock than the stock itself. This, in Greenblatt's world of value investors, counted as heresy. […]. Greenblatt's simple point: When the value of a stock so obviously turned on some upcoming event whose date was known (a merger date, for instance, or a court date), the value investor could in good conscience employ options to express his views. It gave Jamie an idea: Buy a long-term option to buy the stock of Capital One. «It was kind of like, Wow, we have a view: This common stock looks interesting. But, Holy shit, look at the prices of these options!»

The right to buy Capital One's shares for $40 at any time in the next two and a half years cost a bit more than $3. That made no sense. Capital One's problems with regulators would be resolved, or not, in the next few months. When they were, the stock would either collapse to zero or jump to $60. Looking into it a bit, Jamie found that the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model, made some strange assumptions. For instance, it assumed a normal, bell-shaped distribution for future stock prices. If Capital One was trading at $30 a share, the model assumed that, over the next two years, the stock was more likely to get to $35 a share than to $40, and more likely to get to $40 a share than to $45, and so on. This assumption made sense only to those who knew nothing about the company. In this case the model was total y missing the point: When Capital One stock moved, as it surely would, it was more likely to move by a lot than by a little."


To be continue...