by EEBucks
I’ve seen a few posts of people wanting to learn more, so I decided to share this information I’ve put together. Most probably know this info already, so for those who don’t here ya go:
Contract Pricing
Option premiums are derived from two things: intrinsic value (the option’s inherent value) and time value (the additional premium that is priced into the option). The only factor that influences an option’s intrinsic value is the underlying stock’s price vs. the option’s strike price. Time value is influenced by various factors such as time until expiration, stock price, strike price and interest rates; however, the primary factor influencing time value is the implied volatility. Implied volatility fluctuates the same way prices do; it is relative to the underlying stock and how volatile it is.
Example: Suppose a $50 call option was purchased at a price of $14; currently, the stock is trading at a price of $60 per share. Intrinsic Value: Since the share price is above the $50 strike price, the owner can exercise the option and buy the stock for $50 per share and immediately sell the stock for $60. The intrinsic value of an option is the difference between the strike price and the price of the stock, which in this case is $10. Time Value: This is the additional premium that is priced into an option, which represents the amount of time left until expiration. Since the option is priced at $14, the option premium is priced at $4 more than the intrinsic value.
Impact of Implied Volatility
Impact on Premium: Implied volatility represents the anticipated volatility of a stock over the life of the option. As these expectations change, so do the options premiums. As expectations / demand for an option increases, the implied volatility will also rise resulting in high-priced premiums. The opposite is also true, options with lower implied volatility will carry cheaper option prices. In order to make a successful premium trade, buy an option with low implied volatility and sell the option when the implied volatility increases.
Impact on Option Duration: Different types of options result in different reactions to implied volatility. Short-dated options will be less sensitive to implied volatility. Long-dated options will be more sensitive to implied volatility. This is because long-dated options have more time value priced into them whereas short-dated options have less. In order to make a successful premium trade for a short-dated option, buy an option with a higher intrinsic value because time value is less priced in. In order to make a successful premium trade for a long-dated option, buy an option with a low implied volatility because the time value is more priced in; when implied volatility begins to increase, the higher sensitivity will result in a larger, more dramatic premium increase.
Impact on Strike Price: Each strike price will respond differently to changes in implied volatility. Near The Money (NTM) options are most sensitive to changes in implied volatility while options that are further Outside The Money (OTM) or further Inside The Money (ITM) be less sensitive to implied volatility changes.
Implied Volatility and Forecasting: Before initiating an options play, it is beneficial to establish an implied volatility range for the option you will be trading in order to determine what you consider to be low premiums (for buying the contract) and high premiums (for selling the contract) for that specific stock option (it is good practice to also find the mean). Implied volatility moves in cycles, high volatility periods are followed by low volatility periods and vice versa. Investors can use these ranges in order to determine the best time to enter a trade, forecasting is then used to determine a higher implied volatility to exit the trade at. It is important to consider the following when forecasting implied volatility: – Determine whether the implied volatility is high or low and whether it is rising or falling. As implied volatility reaches extreme highs or lows, it is likely to revert back to its mean. – It is not uncommon to see implied volatility plateau at highs, check the news and research the company as this can happen ahead of earnings, mergers/acquisitions, and product approvals. – Consider selling strategies when options are trading with high implied volatility because options premiums will be more expensive. – Consider buying strategies when options are trading with low implied volatility because options premiums will be less expensive.
The Greeks
The Greeks are a set of risk measures that indicated how exposed an option is to time value decay, implied volatility, and pricing changes in an underlying security. There are five Greek risk measures: Delta, Theta, Vega, Gamma, and Rho:
Delta: This is a measure of the change in an option’s price or premium resulting from a change in the underlying asset. A high Delta option’s premium will increase more than a low Delta option’s premium for every $1 the stock gains; a high Delta option’s premium will also fall more than a low Delta option’s premium for every $1 the stock loses. For example, if the Delta is 0.6 then for every $1 the stock rises the premium will rise $0.60. Delta is also commonly used when determining the likelihood of an option being ITM at expiration. For example, an OTM call option with a 0.20 Delta has roughly a 20% chance of being ITM at expiration, whereas a deep ITM call option with a 0.95 Delta has a roughly 95% chance of being ITM at expiration. Lastly, Delta is used when determining directional risk. Positive Deltas are long (buy) market assumptions and negative Deltas are short (sell) market assumptions. Neutral Deltas are neutral market assumptions. There are three main things to keep in mind when considering Delta: – Delta tends to increase as expiration approaches for near or ATM options. – Delta is further evaluated by Gamma, which measures Delta’s rate of change. – Delta can also change in reaction to implied volatility changes.
Gamma: This measures Delta’s rate of change over time as well as the rate of change in the underlying asset. Gamma is used to help forecast price moves in the underlying asset. Since Delta values are constantly changing with the underlying asset’s price, Gamma is used to measure the rate of change and provide traders with an idea of what to expect in the future. Since Gamma is a constant that represents the rate of change of Delta, it is useful for determining the stability of Delta, which can be used to determined the likelihood of an option reaching the strike price at expiration. A good way to think of Gamma is the measure of the stability of an option’s probability. If Delta represents the probability of being ITM at expiration, Gamma represents the stability of that probability over time. Gamma values are highest for ATM options and lowest for deep ITM or OTM options. For example, suppose that two options have the same Delta value but one option has a high Gamma and one has a low Gamma. The option with the higher Gamma will have a higher risk since an unfavorable move in the underlying asset will have an oversized impact. High Gamma values mean that the option tends to experience volatile swings, which is a bad thing for most traders looking for predictable opportunities. An option with a high Gamma and a 0.75 Delta may have less of a chance of expiring ITM than a low Gamma option with the same Delta. There are three additional things to keep in mind when considering Gamma: – Gamma is the smallest for deep OTM and deep IMT options. – Gamma is highest when the option gets near the money. – Gamma is positive for long options and negative for short options.
Theta: This measures the rate of time decay in the value of an option or its premium. Time decay is the erosion of an option’s value from the passage of time. As time passes, the chance of an option being profitable or ITM lessens. Time decay tends to accelerate as the expiration date of an option draws closer because there’s less time left to earn a profit from the trade. Theta is always negative for a single option since time moves in the same direction. Theta is good for sellers and bad for buyers. For example, assume an investor is long an option with a Theta of -0.50. The option’s price would decrease by $0.50 every day that passes, all else being equal. There are three additional things to keep in mind when considering Theta: – Theta can be high for OTM options if they carry a lot of implied volatility. – Theta is typically highest for ATM options since less time is needed to earn a profit with a price move in the underlying stock. – Theta will increase sharply as time decay accelerates in the last few weeks before expiration and can severely undermine a long option holder’s position, especially if implied volatility declines at the same time.
Vega: This measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price. Vega represents the amount that an option contract’s price changes in reaction to a 1% change in the implied volatility of the underlying asset. While Delta measures the actual price changes, Vega is focused on changes in expectations for future volatility. Higher volatility makes options more expensive since there is a greater likelihood of hitting the strike price at some point. Vega tells us approximately how much an option will increase or decrease in the level of implied volatility. Option sellers benefit from a fall in implied volatility, and option buyers benefit from a rise in implied volatility. Long option traders benefit from pricing being bid up, and short option traders benefit from prices being dig down. This is why long options have a positive Vega and short options have a negative Vega. For example, if the Vega is 0.25 and the implied volatility increase by 1%, then the option’s bid-ask price should increase by $0.25. If the Vega of an option is greater than the bid-ask spread, then the option is said to offer a competitive spread. This is just one consideration, as too high of a spread could make getting into and out of trades more difficult and/or costly. There are three additional points to keep in mind when considering Vega: – Vega can increase or decrease without price changes of the underlying asset, due to changes in implied volatility. – Vega can increase in reaction to quick moves in the underlying asset. – Vega falls as the option gets closer the expiration.
Rho: This measures the change in option premium due to interest rates. For example, if Rho is 0.25 and interest rates are increased by 1%, the price of the contract would increase by 0.25 / $25. If interest rates are decreased by 1%, the price of the contract would decrease by 0.25 / $25.
Disclaimer: This is a guest post and it doesn’t represent the views of IWB.