-26-
Mr. Natenberg testified that in closing out the spread
transactions, Tandrill experienced a cash outflow. By paying more
than the theoretical maximum value to close out the spreads,
Tandrill reduced its overall profits (if any) or increased its
overall losses. Mr. Natenberg explained that over the life of an
option, the option’s value will vary depending on current market
conditions and the likelihood of changing conditions in the future.
He referred to the Black-Scholes Model.18 The Black-Scholes Model
is a mathematical refinement of the premise that changes in value
of an underlying asset are random. The Black-Scholes Model uses
the laws of probability to determine the price at which an option
would have to trade so that neither the buyer nor the seller of the
option would show a profit in the long run.19
Mr. Natenberg opined that at the moment of expiration, an
option can take only one of two values: Zero if it is out of the
money, and intrinsic value if it is in the money. Thus, at
expiration of the option it is always possible to calculate the
maximum potential profit or loss resulting from any individual
option trade as well as from a trade consisting of multiple
options. Further, the maximum value of a put option spread is the
18 The Black-Scholes Model was developed by Fisher Black
and Myron Scholes in 1973. It is a tool for analyzing an
option’s value.
19 The Black-Scholes Model requires five inputs in order
to generate a theoretical value: Exercise price, expiration date,
price of the underyling instrument, prevailing interest rate, and
volatility.
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