Understanding options pricing is crucial for traders seeking to navigate the complexities of the market. In this article, we’ll break down key factors like time value, implied volatility, and intrinsic value to help demystify how options are priced. Whether you’re a novice or an experienced trader, grasping these concepts will significantly improve your ability to evaluate options and make informed decisions.
Time to Expiration and Implied Volatility Explained
One of the first factors in options pricing is that of time value. Essentially, this is the premium that an option trades for, above its intrinsic value, due to how much time is left before expiring. The greater an option’s time left prior to expiration, the better it is, because there is an added chance that the stock could eventually move in the required manner. The number of days until expiration is one major influencer in determining that precious time premium.
Apart from the time value, another very important determinant in the pricing of options is the implied volatility. Implied volatility refers to the market’s expectation of how much a stock might move in the future. It reflects the perceived risk and potential price fluctuations over the life of the option. Higher implied volatility increases the premium on an option because it is indicative of a greater chance that the stock price might change substantially.
Intrinsic Value vs. Time Value
To understand options pricing better, let’s break down a real-world example. Suppose Apple is trading at $196 and we are analyzing a March 15th call option that has 50 days until expiration. The option costs $7.10, and we can analyze its value by looking at the intrinsic value and time value.
Intrinsic Value: This is the difference between the strike price of the option and the current price of the underlying stock. In this case, if the strike price is $195, then the intrinsic value is $1.13 (196 – 195 = $1.13). This is the portion of the option’s price that is “in the money.”
Time Value: The remaining $5.97 of the option’s price is the time value, which compensates the option holder for the potential that the stock might move further in their favor before expiration. Time value declines as expiration approaches, a phenomenon known as “time decay.”
Why Selling Options is Often Preferred Over Exercising
With options trading, it is generally better to sell an option before it expires than to exercise it, especially if there is remaining time value. If you were to exercise the option, you would capture the intrinsic value but miss out on the time premium.
As such, for example, if you exercised the call option and purchased the stock at $195, then you would have the stock. You would, however forfeit the time value portion of the premium ($5.97 in the case above). In contrast, by selling the option, you can realize the entire premium, including the time value, without actually buying or selling the underlying stock.
Out-of-the-Money Options: The Cost of Going Further
Out-of-the-money options (OTMs) are options whose strike price is further away from the current market price of the stock. For instance, if you’re considering a $205 strike price when the stock is trading at $196, that option would be considered out of the money. The cost of such options will be cheaper than those that are at or in the money because they have no intrinsic value-the’re priced purely on their time value and implied volatility.
As you move further out of the money, the price of the option will continue to fall. A $210 strike price, for instance, is even farther from the current stock price, and thus it would trade for an even lower premium. If an option is far out of the money, then the possibility of becoming profitable decreases, and its time value also decreases.
The Zero Value of Far-Out-of-the-Money Options
An option with the strike price of being many times away from the current stock value is not even worth intrinsic but would have time value based on implied volatility, though that depends on several factors. Nonetheless, once an option goes to an extremely out-of-money position, the prospect of its moving in favour or turning profit is dimmish making it value-less.
Take Apple’s 50-day option where it strikes far above the actual trading price, like it will have a $250 strike with Apple trading at $196. It is almost worthless because the market knows this option may probably not be exercised for many other reasons, since little time is left to bring its price to that specific figure.
Implied Volatility and Its Role in Probability
Implied volatility also helps determine how likely an option will hit the strike price. The greater the implied volatility, the greater the chances that there might be significant movement in prices, and consequently, an increased chance of reaching the strike price prior to expiration.
For instance, if Amazon is more volatile than Apple, an option on Amazon will cost more because the increased volatility increases the probability of its hitting the strike price. This is why implied volatility is such a significant component in options pricing — it gives one an idea of the risk and possibility of profit during the lifespan of the option.
Volatility Comparison Between Amazon and Apple Stocks
If you compare Amazon and Apple, you can see how much more volatile Amazon seems to be. That is to say that an option on Amazon will normally cost more for a given option on Apple because its implied volatility is so much higher. The market prices the increased volatility of Amazon into the option premium, thereby making it a more expensive option.
Conclusion
In conclusion, it is an options pricing model whose major contributors are time value and implied volatility. As time to expiration, intrinsic value, and volatility influence how much one will pay for an option, this enables more savvy and intelligent decision-making in making proper trading strategies. Regardless of whether the options are traded as in-the-money, at-the-money, or out-of-the-money, realizing these contributors can make an enormous difference in options trading.