Matt Kerkhoff's Intro to Options: Part 4
11/03/2017 5:01 am EST
Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational series on understanding options and their role in investment portfolios. This series will run each Friday on MoneyShow.com through December, moving from the basics through increasingly more sophisticated strategies.
Welcome back for the 4th installment of our series on options. The goal of this series is to provide a basic overview on how options can be used to help protect and manage a portfolio.
Part 1 introduced calls and puts, and discussed some of the vocabulary associated with using options. Part 2 focused exclusively on call options, and included examples of buying and selling a call option. Part 3 looked specifically at puts and the conditions under which an investor may want to buy or sell put options.
If you missed any of these articles, consider reading those first to get caught up.
Today we’re going to wrap up the introductory portion of this series by taking a look at the various factors that affect option pricing.
After this article, you should have a basic framework for how calls and puts work, under what conditions an investor may want to trade calls and puts, and how factors in the marketplace affect the pricing of options.
Let’s get started.
In order to buy or sell any type of option, you’re going to need to a basic understanding of where that option price came from and how it was calculated. If you don’t have that, it will be difficult to know whether you’re overpaying when you buy, or not charging enough when you sell.
In total there are six factors that will affect the pricing of options. But before we get into those specific factors, we need to discuss the concept of intrinsic vs. extrinsic value.
When we talk about the value, or price of an option, we can break this into two buckets: intrinsic value and extrinsic value. Every option’s price is made up of these two components.
Intrinsic value refers to how much value the option would have if it were exercised today. It’s calculated as the difference between the strike price of the option and the current price of the underlying security.
Here’s an example: Let’s say ABC stock is trading at $25 per share, and you’re looking at buying a call option that has a strike price of $20 and is priced at $8. In this case, of the $8 premium, the intrinsic value portion is $5.
Why is this? Because if the option were exercised right now, it would allow the owner to purchase 100 shares of ABC stock at $20 per share, which he or she could then immediately sell back into the market at $25 per share. This means that there is a baked-in value of $5.
You may be quick to point out that at any given time, the underlying share price will be fluctuating. This is correct, and implies that the intrinsic value component of an options price is always changing. Keep this in mind as move along.
Now let’s talk about extrinsic value. Calculating extrinsic value is very simple; it’s simply the amount of the option’s price that isn’t intrinsic value. In our example above, since our $8 call option has $5 worth of intrinsic value, it means that the extrinsic component is $3. Make sense?
This is a good opportunity to introduce some additional vocabulary that you will hear when talking about options. These terms are “in-the-money,” “out-of-the-money” and “at-the-money.” It’s worth taking a minute or two to understand these terms because they are ubiquitous when it comes to trading options.
In-the-money, out-of-the-money and at-the-money simply refer to the relationship between the strike price of an option and the price of the underlying security.
Continuing with our prior example, let’s say ABC stock is still trading at $25 per share. In this case, any call option with a strike price below $25 is considered “in-the money,” a call option with a strike price of exactly $25 is “at-the-money” and any call options with strike prices above $25 would be “out-of-the-money.”
Now, based on this, can you tell me what type of call option we were looking at earlier? (It had a strike price of $20 and was priced at $8.) If you said it was an “in-the-money” call option, you’re correct.
As a quick note, make sure you realize that in, out and at-the-money options are reversed for put options. That is, an out-of-the money put option is one that has a strike price below the current price of the underlying security. An in-the-money put option would have a strike price above the current price of the security.
Now let’s tie together these two concepts of intrinsic/extrinsic value and in, at and out-of-the-money options.
If you’re paying close attention, then you probably noticed that any option that has intrinsic value will be an “in-the-money” option. Said differently, this type of option would have value if exercised today.
An out-of-the-money option, on the other hand, has no intrinsic value. If this type of option were exercised today, it would provide no value to its owner. For out-of-the-money options, the entire price (or premium) of the option is comprised of extrinsic value.
Hopefully this is all making sense. If not, take a moment to reread this section. Understanding in, at, and out-of-the-money options is crucial because when we start getting into specific strategies, we’ll find that strike price selection (using in, at, or out-of-the-money options) is very important.
Now that we have a grasp on intrinsic vs. extrinsic value, we can get into the six factors that affect option prices. These six factors can be categorized as affecting either the intrinsic or extrinsic component of an option’s price, and are listed in the table below.
Before we get too far, I can tell you that only the top two factors in either column above really matter. The other two (interest rates and dividends) have such a small effect on option pricing that we don’t need to concern ourselves with them. For now, we’ll focus on the other four.
Current Price of the Underlying Security
This one is probably self-evident based on our discussion above. As the price of the underlying security changes, the price of all options tied to that security are going to change as a result. This plays out differently depending on whether we are talking about call or put options.
In our example above, where we looked at buying (going long) a call option in ABC stock, any rise in the underlying security’s price is going to cause an increase in the price of all call options. At the same time, it’s going to cause a decrease in the price of all put options.
The reverse is also true. A decrease in the price of the underlying security will cause call option prices to fall and put option prices to rise.
One important thing to note here is that the effect that a change in the price of the underlying security has on the price of an option depends on whether that option is in or out-of-the-money, and by how far. We won’t go into detail on this yet, but it’s something to keep in mind.
Strike Price of the Option
The strike price of an option will never change once bought or sold, but strike prices play an important role in determining the initial price that you pay (or receive) for an option.
Let’s say ABC stock is again trading at $25 and we want to purchase a call option. If the $20 strike price call is trading at $8 (as in our earlier example) then do you think a call option with a strike price of $23 would be more or less expensive?
If you said less expensive, you’re correct. To understand why, we need to look at the effect the strike price has on intrinsic and extrinsic value.
In this case, with ABC stock trading at $25 per share, the $23 strike price option only has an intrinsic value of $2 per share ($25 - $23). With less intrinsic value, this option will trade at a discount to the $20 strike price option (which has $5 in intrinsic value per share).
As we move from in-the-money call options to out-of-the-money call options, the same dynamic of cheaper option prices prevails.
A call option with a $30 strike price will cost less than a call option with a $28 strike price because the chance of the $28 call option having value by expiration is much higher (the stock would have to rise above $30, not just $28, for the $30 strike price option to have value at expiration).
Once again, keep in mind that this relationship reverses when we talk about put options instead of call options.
Days Left to Option Expiration
Now we’re moving from Intrinsic Value factors over to Extrinsic Value factors. At this point, I want to introduce a new term called “time value.” From this point on, we’re going to refer to extrinsic value as time value. You’ll see why momentarily.
Recall that any option’s price is always made up of intrinsic value and extrinsic value. Any portion of an option’s price that is not intrinsic value is extrinsic value. Well …what exactly is extrinsic value then?
In laymen’s terms, it’s the probability that the underlying stock’s price will change to a level that creates value for the option holder. If you think about it, this is primarily a function of how much time is left before the option expires. Thus we refer to it as “time” value.
One dynamic that is critical to understand is that as an option approaches its expiration date, the amount of extrinsic value will erode to zero. This makes perfect sense if we think of extrinsic value as “time value” instead.
When more time is left in an option, there is a greater likelihood that the underlying security could see a move that increases the value of our option. But as time slowly ticks by, the chance of the underlying stock moving profitably for us declines.
On the day of expiration, there is no more extrinsic value or “time value” left in the price of the option. The entire price at that point is made up of intrinsic value (that is, if there is any intrinsic value … options that are “out-of-the-money” (don’t have intrinsic value) will expire worthless.
To summarize, all options that have not expired yet have some amount of “time value” built into the price. The more days left to expiration, the more time value in the price. But as those days tick by and eventually run out, all the time value is gone and the price at expiration reflects only the intrinsic value of the option.
The last of the four primary factors that affect option prices is volatility, and this one you should understand intuitively.
Volatility is a measure of how much a stock’s price tends to bounce around over time. A stock with high volatility will see sharp swings in price, while a stock with low volatility will see more subdued changes in price.
When we own a call or put option, we are betting that the price of the underlying security will move in a certain direction, and be of significant magnitude, to be favorable to us. The “magnitude” portion of this relationship is where volatility comes in.
Imagine you have two stocks, X and Y, that are both trading at $25 per share. Stock X often trades in a tight range between $24 and $26 per share, while stock Y has a much larger range, frequently trading between $20 and $30 per share.
In this case, stock Y has higher volatility, and therefore its options will be more expensive than stock Y’s, all else being equal.
One last thing to note about volatility is that there are two types: historical and implied.
Historical volatility is exactly that; it’s the actual, observed volatility of a given security over a certain time period. Implied volatility is an artificial measure of volatility that is “backed out” of the price of options, very similar to how the VIX is calculated.
When it comes to options, we care more about implied volatility than historical volatility. Historical volatility will give us an idea of how much the underlying security’s price has moved around over time, but implied volatility will tell us how much volatility is to be expected over the term of the option in question.
One area where we see implied volatility differ greatly from historical volatility occurs around earnings reports or other big announcements. Option contracts that expire shortly after these types of events often see higher levels of implied volatility, due to these events causing big swings in the underlying stock’s price.
When it comes to volatility, the key takeaway is that higher volatility means higher option prices, and vice versa. In some cases, the amount of volatility currently in the market will actually determine which strategies we use, and which side of the trade we take.
If you’ve made it this far and have a decent grasp on the things we’ve covered, congrats, this is not easy stuff.
At this point we’ve covered much of the basics of calls and puts, and options trading in general. From this point on we’re going to begin discussing specific strategies that can be applied to protect and manage an overall portfolio.
Next we’ll look at one of the most important uses of options: Protecting your Investments with Portfolio Insurance.