3 Fundamental Forces in Option Pricing
06/11/2012 11:35 am EST
The options world is ruled by a trio of fundamental forces that impact the price of options, writes Dan Passarelli, and ignoring the impact of these forces significantly lowers the odds of a profitable trade.
In an attempt to understand the complexities of the world they observed in daily life, ancient Babylonian philosophers considered all things to be constituted of one or more of the four classical elements of earth, air, water, and fire.
In this world view, the natural environment was considered to consist of various objects composed of varying portions of each of these fundamental elements or forces. While modern atomic theory has supplanted this early concept, these historic constructs can provide a helpful organizational structure within which to consider the importance of fundamental, primal forces impacting various option trade structures.
Similar to the early view of the Babylonians, the options world is ruled by three primal forces consisting of 1) price of the underlying, 2) time to options expiration, and 3) implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces has when designing the anatomy of the options trade under consideration.
See related: The 3 Primal Forces of Option Trading
For the new options trader, learning about options and the impact of these three fundamental forces may be confusing, and the magnitude of the influence of each on the profitability of trades is easily underappreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders come from the universe of stock traders where “only price pays,” the initial reluctance to consider additional factors impacting a trade is easily understood.
In order to help understand the initially confusing manner in which options respond to their milieu, it is helpful to dissect an option’s price into its two components: extrinsic value and intrinsic value.
Remember that the quoted price of an option reflects the sum of the intrinsic (if any) value and extrinsic value. Intrinsic value of an option is that portion of the premium which is in the money and impacted solely by the price of the underlying. Extrinsic value is also known as time premium (or less generously, “sizzle,” as opposed to “steak” of the intrinsic value) and is impacted by both time to expiration and implied volatility (IV).
Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are conversant with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock’s price action are well beyond the scope of this discussion, but suffice it to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.
The price influence of time is easily understood, in part because it is the only one of the forces restricted to unidirectional movement. The core reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.
The third price influence is perhaps the most important. It is without question the most neglected and overlooked component: implied volatility. Implied volatility taken together with time defines the magnitude of the extrinsic option premium.
The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can wax and wane as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).
New traders beginning to become familiar with the world of options trading should direct their attention to understanding the impact of each of these options pricing influences. The options markets are ruthlessly unforgiving to those who choose to ignore the impact of the valuation metrics that underpin daily life in their world.
See also: Option Greeks: The 4 Godfathers of Risk
By Dan Passarelli of MarketTaker.com