Introduction to Options #3 - Option Premiums

What drives the price of an option premium?


Unlike other terms of an option contract, the option premium is the option’s market price, determined by supply and demand (bids to buy, and orders to sell). Although activity in the underlying asset, as well as things like expiry and exercise shape it, the best way to assess an option’s premium is:


Option premium = intrinsic value + time value


What is intrinsic value?


Intrinsic value is the variance between the current price of the underlying asset and the exercise price of the option. It is not possible to have intrinsic value below zero.

  • A call has intrinsic value if the underlying asset is priced above the option exercise price

  • A put has intrinsic value if the underlying asset is priced below the option exercise price

Effectively, exercising the option provides greater value than buying or selling the asset on market. When this favours the option-holder, they are deemed to be ‘in the money’. If it does not, they are ‘out of the money’, or ‘at the money’ when the asset price is near the exercise price.


What is time value?


Since an option provides its holder with the benefit of time before they make their decision as to their rights over the underlying asset, it adds a premium to the value of the option.

The portion of the premium above and beyond the intrinsic value is referred to as time value.


This explains why sometimes you will see an option that is out of the money and has no intrinsic value, yet there is a premium attached to it. However, when an option is either in or out of the money, there is less time value attributed than when it is at the money, since intrinsic value is minimal.


Options differ to shares in that their finite life drives their value. Shares do not have time value because they do not expire. As such, time value is influenced by its own factors:

  • Time to expiry

  • Volatility of the underlying asset

  • Dividends

  • Interest rates


Time to expiry


With greater time to expiry, an option commands more time value and in turn a higher premium. This is because it grants the option-holder the time and likelihood for the underlying asset to perform as they expect, be it higher (for a call), or lower (for a put).

Time decay occurs as time passes and value shrinks, although the relationship for this is not inverse. Some experts suggest an option loses one-third of its time value during the first half of its life cycle, with the remainder quickly thereafter.


It is important to be aware of time decay when buying an option as it will mitigate the premium. On expiry, there is only intrinsic value remaining. This makes options trading a strategic focus, between time, cost and asset outlook. For this reason, options with later expiry dates are often dearer.


Volatility of the underlying asset


Volatile assets generally command a larger option premium because they provide holders more chance of a big variation from the exercise price. There is also risk for the party writing the option, so they look to be compensated accordingly.


Some assets are more stable than others. Volatility, measured in standard deviations, can work in both directions. This explains why option premiums apply to both calls and puts. Many traders use probability theory to predict a trading range, such that:

  • 19 out of 20 times the asset price will be within 2 standard deviations of its current price

  • 2 out of 3 times the asset price will be within 1 standard deviation of its current price


Dividends


A stock that goes ex-dividend usually reduces by the value of the dividend. Because this is forecast in advance and priced into the option already, there is often little impact on the option premium. However, should a dividend differ from that expected, option premiums change.


The premium of a call will be lower when an ex-dividend is expected during its life, since the underlying stock will drop. Under the same circumstances, the premium of a put will be higher for the same reason.


Interest rates


There is time value associated with the period between which you acquire an option and then decide what to do with your rights attached to it. In this time, funds can be used elsewhere, earning interest. Call options therefore have a funding benefit and premium, which increases with higher interest rates.


When it comes to puts, time works against you as far as receiving cash. Higher interest rates will increase your funding cost and lower the option premium, with the opposite true when rates decrease.


Working out the option premium


Some traders use an option pricing model (e.g. Black & Scholes) to estimate the premium based on the above variables. This value is likely to differ from market prices, but can be used as a guide to determine how ‘fair’ it is. While some variables like exercise price and expiry can be accurately gauged, others like dividends and volatility must be assumed because they are forward looking.


For this reason, historical volatility is sometimes measured from the past and used. Alternatively, traders use implied volatility, which is the level that equates with the option’s current premium. Therefore, it is worked out backwards using a pricing model. This gives a measure of the market’s confidence of how volatile the underlying asset is during the option’s life.


When compared with a forecast level of volatility, or historical volatility:

  • If implied volatility is high, the option may be deemed overvalued and worth selling

  • If implied volatility is low, the option may be deemed undervalued and worth buying


Can option pricing models show anything else?


Option pricing models may also give rise to delta, which measures sensitivity between the value of an option and shifts in the price of the underlying asset.


Asset pricing shift x option delta = estimated variance in option price


Delta has a relationship with the option exercise price. The further a call is in the money, the closer delta is to ‘1’ and the greater the sensitivity of the option when the underlying asset price increases. The further out of the money, delta approaches 0 and there is minimal responsiveness. The mid-point of 0.5 is when the option is at the money.


When the asset price changes, so too does delta. This is particularly the case when the asset rises and approaches the exercise price, leading to the value of the call quickly appreciating.

If the option is a put, delta will follow an inverse relationship. The more it is in the money, the closer delta is to ‘-1’ and the greater the sensitivity of the option when the underlying asset price decreases. The further out of the money, delta approaches 0 and there is minimal responsiveness. The mid-point of -0.5 is when the option is at the money.


Summary


  • The premium of an option is made up of intrinsic value and time value

  • Intrinsic value is the variance between the current asset price and option exercise price

  • Time value is the notion that an option commands a premium above the intrinsic value, which is influenced by time to expiry, volatility of the underlying asset, dividends and interest rates

  • Time decay ensures the option premium decreases as it approaches expiry

  • Volatile assets generally command a larger option premium

  • Options are usually priced to account for dividends, but can create opportunities both ways

  • Interest rate movements affect funding benefits of calls, and funding costs for puts

  • Implied volatility may be compared with historical volatility to assess ‘fairness’ on whether an option is overvalued and worth selling, or undervalued and worth buying

  • Delta measures the sensitivity of an option to movement in the underlying asset, with greater movements the further an option is in the money

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