Time Value and Intrinsic Value
An option’s price has two components; its intrinsic value and time value. Intrinsic value is an option's inherent value as it relates to the price of the underlying stock and its very own strike price. If you own a $100 call on a stock that is trading at $120, this means that you can buy the stock at the $100 strike. You can then immediately sell it in the market for $120. This defines the option’s intrinsic value; in this case it is: $120 - $100 = $20. The only factor that influences an option's intrinsic value is the underlying stock's price versus the option's strike price. No other factors influence the option's intrinsic value.
Using the same example, let's say this option is priced at $24. This means the option premium is priced at $4 more than its intrinsic value. This is where time value comes into play.
Time value represents the additional premium that is priced into an option based on time left until expiration. Time value is influenced by various factors, including time until expiration, stock price, strike price, and interest rates. The most significant factor in time value, though, is implied volatility.
How Implied Volatility Affects Options
Implied volatility is the market's forecast of a likely movement in a security's price. It is a metric used by investors to estimate future fluctuations (volatility) of a security's price based on certain predictive factors. Implied volatility, denoted by the symbol σ (sigma), can often be thought to be a proxy of market risk. It is commonly expressed using percentages and standard deviations over a specified time horizon.
When applied to the stock market, implied volatility generally increases in bearish markets, when investors believe equity prices will decline over time. IV decreases when the market is bullish, and investors believe that prices will rise over time. Bearish markets are considered to be undesirable, hence riskier, to the majority of equity investors.
Implied volatility does not predict the direction in which the price change will proceed. For example, high volatility means a large price swing, but the price could swing upward—very high—downward—very low—or fluctuate between the two directions. Low volatility means that the price likely won't make broad, unpredictable changes.
The DTE (days until expiration) on a contract also plays a role on how much an option is swayed by implied volatility. Shorter term options will be less sensitive to IV, whereas longer term options will be more sensitive. Since longer term options have more time value priced into them, implied volatility plays a larger role in pricing of the option.
Each strike price will also respond differently to implied volatility changes. If the stock is trading close to the strike price of an option (near-the-money), the contract will be sensitive to IV changes. On the other hand, options that are further in-the-money (when the contract can be exercised; e.g. current trading price of a stock is greater than the strike price of a call) or further out-of-the-money (when the contract cannot be exercised; e.g. current trading price of a stock is greater than the strike price of a put) will be less sensitive to changes in IV.
How is Implied Volatility Calculated
IV can be determined by using an option pricing model. It is the only factor in the model that isn't directly observable in the market. Instead, the mathematical option pricing model uses other factors to determine implied volatility and the price of the option. Two widely used models include:
- The Black-Scholes Model a widely used and well-known options pricing model, factors in current stock price, options strike price, time until expiration (denoted as a percent of a year), and risk-free interest rates. The Black-Scholes Model is quick in calculating any number of option prices.
- The Binomial Model, on the other hand, uses a tree diagram with volatility factored in at each level to show all possible paths an option's price can take, then works backward to determine one price.
Four Things to Consider When Forecasting Implied Volatility
1. Make sure you can determine whether implied volatility is high or low and whether it is rising or falling. Remember, as implied volatility increases, option premiums become more expensive. As implied volatility decreases, options become less expensive. As implied volatility reaches extreme highs or lows, it is likely to revert to its mean.
2. If you come across options that yield expensive premiums due to high implied volatility, understand that there is a reason for this. Check the news to see what caused such high company expectations and high demand for the options. It is not uncommon to see implied volatility plateau ahead of earnings announcements, merger-and-acquisition rumors, product approvals, and other news events. Because this is when a lot of price movement takes place, the demand to participate in such events will drive option prices higher. Keep in mind that after the market-anticipated event occurs, implied volatility will collapse and revert to its mean.
3. When you see options trading with high implied volatility levels, consider selling strategies. As option premiums become relatively expensive, they are less attractive to purchase and more desirable to sell. Such strategies include covered calls, naked puts, short straddles, and credit spreads.
4. When you discover options that are trading with low implied volatility levels, consider buying strategies. Such strategies include buying calls, puts, long straddles, and debit spreads. With relatively cheap time premiums, options are more attractive to purchase and less desirable to sell. Many options investors use this opportunity to purchase long-dated options and look to hold them through a forecasted volatility increase.