What Really Drives Option Premium?

07/16/2012 7:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Expert Alan Ellman takes a look at implied volatility, although this metric doesn't tell the whole story when it comes to premium value.

What makes some stock option premiums worth so much more than others?

Let’s say we have two stocks, A and B. Both are trading at $25 a share. We look to sell the same month at-the-money $25 strike and one (stock A) returns 2% and the other (stock B) 4%. Why?

The answer lies predominantly in the mysterious world of implied volatility (IV). The volatility of an option reflects the forecast fluctuation in the price of the underlying stock, both up and down. It does not predict a trend, but rather a range of price change that the equity can have. In this case, stock B has a much higher IV than does A.

Let’s revisit our equation of the factors that determine the value of an option premium: Intrinsic Value + Time Value = Premium Value.

Intrinsic value is the amount of money the strike is below the market value of the equity, nothing more or less. It is not affected by stock volatility or anything other than the value of the underlying security. Therefore, volatility of the stock relates only to time value.

Now take a big gulp of high-octane coffee as I review some definitions:

Historical Volatility (Statistical Volatility): A statistic or statement of fact based on the closing prices over the past year. If a stock has had a trading range between $30 and $40 and has an average price of $35, we can say the historical volatility is $5 in either direction. A stock that moves up or down $5 from its average of $35 is said to have an HV of 14.3% (5/35). It does not predict a future direction.

Implied Volatility: This is the market’s estimate of future volatility and is based on the option’s last traded price. Stated differently, it is the volatility that the market as a whole is expecting that is giving the option premium its current value. If the historical volatility (HV or SV) is @ 14.3% and the current implied volatility is @ 30%, then that option is considered overpriced.

Common sense formulas:

  • As IV increases = Call premium increases
  • As IV decreases = Call premium decreases

Causes of implied volatility changes:

  • changes in stock volatility
  • supply and demand
  • earnings reports
  • rumors
  • news
  • market psychology and volatility
  • world events
  • political events

Mathematics of Implied Volatility
In statistics, we often hear the term standard deviation. This means that a certain event will occur based on a statistical model, a certain percentage of the time.

Let’s clarify this with an example using my favorite theoretical stock: Blue Collar Investor Corp. (BCI) is currently trading at $60 per share (I wish!). A pricing model like the Black-Scholes determines that, based on the current market value of the call option ($60 strike, for example), the IV is 25%. This means that the market is anticipating a price change of $15 (25% of $60) up or down.
Remember, it does not identify a trend.

The expected range for the year currently is between $45 and $75 (plus or minus 25% of $60). The likelihood of this being accurate is one standard deviation, or 68% of the time. It will fall outside these limits 32% of the time. Bottom line: When IV percentages are quoted, they are based on the current option value and on 1 standard deviation.

Where to access Historical and Implied Volatility stats? Use this link for iVolatility.com. You can access volatility charts which compare historical and implied volatility. Here is one such chart:

chart
Click to Enlarge

This chart was captured a few days prior to the earnings report for ADTN. It is no surprise that the IV (red arrow) is higher than the HV (green arrow), as the market is anticipating a short-term price fluctuation due to a potential positive or negative earnings surprise.

BCI Guideline: If a one-month at-the-money option returns more than 6% to 7%, the market is anticipating a large price change by expiration Friday. In most instances, I will avoid these situations and target a 2% to 4% return.

Exceptions to this guideline include strong bull markets and the use of in-the-money strikes to hedge against potential negative price movement. (For more information on strike price selection, see pages 108 to 124 of Alan Ellman’s Encyclopedia for Covered Call Writing.)

Conclusion: Our stock option premiums consist of intrinsic value (for in-the-money strikes only) and time value. The volatility of the underlying equity impacts only the time value. The greater the implied (forecasted) volatility, the richer the option premium. The direction of price movement is not inherent in implied volatility stats, which are based on one standard deviation.

Alan Ellman can be found at The Blue Collar Investor and will be speaking at the upcoming Forex & Options Expo.

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