Lessons from the Pros

Options

# Option Prices and Stock Prices – Great Expectations

The prices of options are affected by changes in the price of the underlying stock, and by the passage of time. Today, however, we’ll examine the third major force that affects the price of options – the power of expectations. This force has a mathematical-sounding name. It is called Implied Volatility. It’s probably the least understood influence on option prices, and it is often the most important one.

Now, an option’s value has two parts: part one is intrinsic value,  which is the actual discount to market value the option offers, if any. If IBM stock is at \$140 per share, and I have a call option that gives me the right to buy shares of the stock at \$135 per share, then I have the right to buy it at a \$5 discount. That option’s intrinsic value is that \$5 discount. If before I exercise the option, IBM’s stock drops to \$132, then my right to buy it for \$135 is no longer at a discount to market value. That option would have no intrinsic value unless IBM climbed that \$3.00 back above \$135 again. This might or might not happen before the option expired. If not, then at expiration the option would be worthless.

Part 2 of an option’s value is extrinsic value, also called time value. Even if IBM’s stock did drop to \$132, so that our \$135 call option had no intrinsic value, that option might not be worthless because it might still have time value. If there were enough time in the option’s remaining life for it possibly to climb back above \$135, then that \$135 call would still have time value.

Let’s say that the option was expiring in three days. IBM’s stock price on an average day swings in a range a little less than \$2.00 wide. It has, on occasion in the last year, moved over \$10 in a day. So, there is a reasonable expectation that IBM could move up by \$3.00 (from \$132 to \$135) in three days. People would be willing to pay something for that chance. That amount would be the option’s time value.

How much they were willing to pay for the time value would depend on just how likely they thought it was that IBM would make that \$3 move. A starting point for that evaluation would be how much IBM has moved on average in the past, as laid out above. There is a mathematical model, called the Black-Sholes model, that calculates how much that chance should be worth, assuming that IBM moves as it has in the past. That calculation’s result is the option’s theoretical value, which includes both its intrinsic and time value.

But people don’t always believe that a stock will move in the future in swings of the same magnitude that it has in the past. If the option market participants believe that the stock will move more quickly, they will pay more for the time left in the option than the theoretical value; if slower, they will pay less. And that belief can change in an instant. Any story, report or rumor that changes people’s expectations for the rate of price movement will change the amount that they pay for options. In fact, the Black-Scholes model can calculate backwards from the price at which an option is being traded in real life, to the amount of price movement that the buyer must have been anticipating when they paid that price. That anticipated movement is called implied volatility. By paying whatever price he/she paid, a buyer has implied that he/she believes that the stock will move enough to make a profit on the option.

All of this boils down to something that savvy option traders could use to enhance their profits. When option prices are inflated by unreasonable expectations of future stock price movement, it’s a good time to sell options at those inflated prices to those willing buyers. Soon enough, it is likely that their expectations will come back to earth and the option prices will come down. The option sellers could then buy back the options they sold for lower prices and make a profit.

On the other hand, when option prices are deflated by unreasonably low expectation of future stock price movement, in other words, option prices are depressed, it is usually a good time to initiate trades to buy them, rather than to sell them short. When expectations later return to normal, the re-inflation of the option prices means that they could then be sold at a profit.

We’ve laid out the outlines of the three forces that change option prices – stock price change, time value, and expectations. Knowing that all three forces exist is the first step in learning how to harness them for profits. Although there is a learning curve, it is well worth it. Once you understand options, they have the potential to be a valuable tool for managing investments.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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