How Peter Muller Taught me to Think About Options

We don’t live in a risk neutral world

Photo by Kaysha on Unsplash

Here’s a question traders and investors like to ask frequently:

what implied probability has the market embedded for a given future event?

This question arises from the view that a market is a discounting mechanism for expected future cash-flows. And, the fact that unpredictable news affects those potential cash-flows, so the price of anything traded is affected by unpredictable, i.e. random, future events.

There are, of course, many kinds of markets, and stock markets are not the only one. Racetrack betting is a market, for example, where the price of participation is expressed as the odds on a particular outcome. In fact, many sports betting venues possess the same properties:

1. there is an unpredictable, binary, outcome that we wager on;
2. there is a competition that costs money to enter and will deliver a payoff should the outcome occur;
3. the price of wagering is expressed in terms of the ratio of the cost to enter the competition and the payoff delivered — and this price is affected by supply and demand.

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