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Options pricing

Lesson in Course: Derivatives and options (advanced, 5min )

When deciding to buy an option, how do I make sense of the current cost?

Eureka!
  • What it's about: Different reasons why an option's price can be high or low.
  • Why it's important: Low-price options do not always represent good deals.
  • Key takeaway: Bargain or value shopping for options requires a much deeper understanding than simply looking at the option's price.

Everyone loves a good discount. But at what point does a discount become suspicious?

When we start looking at option chains, we'll notice that prices vary between deep-in-the-money options and out-of-the-money options for the same stock. We'll also see prices differ significantly between options contracts on different underlying stocks. What causes these differences, and how do we make sense of them?

Intrinsic value adds to the price

In-the-money options cost more to purchase than out-of-the-money options with the same maturity. Intuitively, we can make sense of this by thinking about the intrinsic value. An in-the-money option has the potential to make money for the holder if it's exercised today whereas an out-of-the-money option is guaranteed to lose money if exercised.

Call options

Visually, we can graph the intrinsic value and extrinsic value of a call option as the stock price increases over time.

Call option price breakdown
How To Trade Options: Moneyness and Intrinsic Value - PaulSitarz.com
The blue "Stock payoff" line represents the difference between the stock price and the strike price of the option. Positive values = in-the-money, and negative values = out-of-the-money

In-the-money options have positive intrinsic value and can be found in the top right-hand quadrant in the graph above. Option prices and intrinsic value increases as we get further in-the-money and the option price is made of both intrinsic value and extrinsic value.

On the other hand, if we look at out-of-the-money options (the bottom left quadrant) we can see that the extrinsic value makes up the entire option price. As the option gets further out-of-the-money, both the extrinsic value and the option's price decrease.

Put options

If we draw the same exact graph for a put option, it would look like this.

Put option price breakdown
How To Trade Options: Moneyness and Intrinsic Value 8
The simple trick of reflecting a call option over the Y-axis to generate the put option works in our example.

The put option graph looks identical to the call option with the exception that the intrinsic value of the put option increases when the stock price decreases. 

In both scenarios, in-the-money options have a much higher price than out-of-the-money options.

 

As an option buyer, we need to know what we are buying when we are looking at contracts with low prices. The low price could likely mean that we are buying extremely out-of-the-money options which are extremely risky if they have a short maturity date.

Bigger bets cost more

Option prices cost more for stocks with higher share prices than for stocks with lower share prices. Stocks with higher share prices represent bigger bets for options traders since the price movements are larger on a dollar basis. 

For example, let's take a look at two stocks that have similar price movements but different share prices.

Percent change vs dollar change

The stock prices for both $TSLA and $LMND are currently up just over 1% for the day. If we own a single share of both stocks, we would receive $8.81 in profit for owning $TSLA and $0.70 in profit for $LMND. If we bought a single call option for both stocks, our call option on $TSLA netted us a lot more than $LMND for a 1% increase in stock price.

 

The price for an option on a higher-priced stock like $AMZN can often be unaffordable. If this is the case, the mistake we absolutely want to avoid is to get around this by buying super-out-of-the-money options on the same stock. While the price of these options is much cheaper, we can lose all our money very quickly depending on how soon the options mature.

The need for insurance

In a previous lesson on implied volatility, we learned that high IV makes option prices expensive. We can imagine the relationship between IV and option price with the demand for insurance—during times of extreme uncertainty, investors want the insurance provided by options and are willing to pay more for the insurance. 

When looking at an option's price, it's always a good idea to compare historical volatility with the current implied volatility. Buying an option when the current IV is much higher than the historical volatility means we are buying at the same time that other investors are shopping for insurance and can result in overpaying for our contracts. Likewise, selling options when IV is lower than historical volatility, means that we could be selling during the time that everyone is getting rid of their insurance. The market would be underpricing our options contract.

Understanding how to compare volatility is an advanced concept that is applied situationally. We will cover this topic in more detail in future lessons.

Actionable ideas

The biggest pitfall we want to avoid is to bargain bin shop for out-of-the-money options. Before we pull the trigger on a very cheap option, we should take a look at the break-even and the delta. This will help us gain an understanding of the likelihood that the option can be valuable.

 

Supplementary materials

A free tool to look up historical volatility. 

Historical and implied volatility

OIC: The Options Industry Council—optionseducation.org

https://www.optionseducation.org/toolsoptionquotes/historical-and-implied-volatility

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