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4
Options 101
Part 22
As stated earlier, it is the “scoring potential” of the teams that drives the values of the bets. And that means that time plays a critical role since teams can produce higher scores the longer they are allowed to play. For example, if the basketball bet was only good for the first five minutes of the game then you should be willing to pay less than if it applied to the entire game.
It’s exactly this same reasoning that drives the true time premium component (the component above the cost of carry) of an option. If you have a $20 call, it will have intrinsic value for every price above $20 at expiration. If the stock closes at $23 at expiration, the call will be worth exactly $3. If it closes at $32, the call will be worth $12. How much will you pay for this $20 call? As with the sports bet, the answer depends on the “scoring potential” of the stock. If you are dealing with a stock whose price fluctuates wildly, you will pay much more for the call than if the stock price hardly moves. If there is more ability to make money on the bet, then the bet should be worth more money. In option trading, the “scoring potential” is known as volatility. A high-volatility stock has large price fluctuations. It can be up or down several percentage points in a day. A low-volatility stock, on the other hand, has almost no fluctuations in its price. The time value portion of an option is solely determined by the market’s perception as to the volatility of the stock between now and expiration. There is no way to say for sure if the time premium is too high or too low. It is strictly a value that exists in the minds of the traders.
To further understand volatility using an everyday example, we would say that gas prices are more volatile than milk prices. We’re pretty sure that a gallon of milk will cost about the same next week or next month but we’re not nearly so sure about a gallon of gas. While there are many ways to measure the volatility of a stock, that’s getting a little ahead of our goal. Just understand that the more volatile the stock’s price – the more uncertain its price is from day to day – the more money you’re going to pay for an option. High-volatility stocks have greater potential to move higher, and traders are therefore willing to pay higher time premiums for the option. It is the high-volatility stocks that carry the largest time premiums on their options.
For example, imagine that you are looking at two options:
ABC Jan. $50 call = $2
XYZ Jan. $50 call = $6
Both underlying stocks are $50 and both options expire at the same time. What can we conclude about the relative volatilities of these two stocks? We can conclude that XYZ must be more volatile than ABC, which is why traders are willing to pay more for that call option. XYZ is like a high-flying tech stock while ABC is more like a blue-chip company.
At the beginning of this chapter, Principle #2 conveyed that longer-term options are worth more than shorter-term options, so we know the ABC or XYZ March $50 calls will be worth more than the January $50 calls. Now you probably understand better why that is. For any given stock, the longer the timeframe, the better the chance for “high scores” or high stock prices, and that makes the value of calls and puts rise. Remember that put options will rise too since stock prices behave a little differently from basketball and football games in that they can rise or fall with equal ease.
There is no way to limit what time value traders will place on an option – it is a value that exists in their heads. It depends on how bullish or bearish traders are at that time. Obviously, if traders are extremely bullish, then they are willing to pay more for the time value. If they think the stock will just sit flat, they may not be willing to pay anything. The time value portion of an option is an indication of the volatility that traders believe the underlying stock will exhibit through the life of the option.
Does this mean that you should only buy options on high-volatility stocks? Although there are many traders who will tell you that you should only trade options on high-volatility stocks, that is actually a misconception. Those options, for reasons just stated, also have the highest time premiums, and that makes it that much harder to earn a profit.
For example, assume you are looking at the ABC and XYZ $50 calls we saw previously. The XYZ $50 call was trading for $6 while the ABC $50 call was trading for $2. The XYZ $50 call certainly has more potential for greater profit but it also costs more.
We can show that the high-volatility stock needs more movement to make a profit by calculating the breakeven points for each option at expiration. To find the breakeven point for a call, we simply add the cost of the option to the strike (we subtract it from the strike for a put option). For the ABC $50 call, this means the stock must close at $52 at expiration in order for the trader to break even. If the stock is $52 at expiration, the $50 call is worth exactly the intrinsic amount of $2. This means you paid $2 for the option and sold it for $2 so you just broke even. The XYZ $50 call, on the other hand, must have the stock close at $56 at expiration in order to break even. If the stock is $56 at expiration, that $50 call is worth exactly the intrinsic amount of $6, which is the amount that was paid for it, so you break even. Notice that the benefits of a high-volatility stock are balanced by the higher breakeven price. The market realizes the benefit in buying high volatility and prices those options higher.
When you hear traders tell you to only buy options on high-volatility stocks, they are unknowingly making the assumption that both options will cost the same. If that were true, you can be sure that the high-volatility options would be the right choice. However, the financial markets will always bid the prices higher for options on high-volatility stocks.
Let’s return to our main idea about what gives an option value. We said the first factor was intrinsic value, which is determined by favorable price movement. The second is due to time, which is affected by traders’ beliefs in the future volatility of the stock. This leads to a very important point about the characteristics of option prices: Option prices can rise or fall with no movement (or with adverse movement) in the underlying stock.
This can happen simply because of a change in traders’ outlooks on the volatility of the underlying stock. For example, assume you buy a three-month $50 call option for $3. A month later the stock is still $50 and the option is trading for $2. However, at that time, a buyout rumor starts circulating on the stock. We might see the $50 call trading for more than $3 even though less time remains on the option and the stock price hasn’t moved. The reason is that traders now believe the “scoring potential” or volatility will be greater in the near future so they are willing to bid the option higher than its price a month earlier.
Exercise
Go to www.cboe.com and check out option quotes on Google (GOOG) and McDonald’s (MCD). Look at the prices for the at-the-money calls and puts. Which stock has the more expensive options? Why?
To be continued….
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