The ‘X-factor’ in Options Trading

Commentary: Understanding the mystery of implied volatility

By Michael Sincere and Mark Wolfinger

BOCA RATON, Fla. (MarketWatch) — One reason why options have a reputation for being so difficult is a mysterious concept called “implied volatility.” This is the unknown factor built into the price of an option.

But before you can understand implied volatility, it helps to know how options are priced.

First, the option premium, or price, is made up of several factors, including the price of the underlying stock, the strike price, how much time is left to expiration, interest rates, dividends, option type (put or call) and the “X-factor”: the volatility of the underlying stock; or more specifically, the estimated future volatility of the underlying stock.

When trying to calculate how much an option is worth, use the following formula:

Option price (or premium) = Intrinsic Value + Time Value. For example: $6.50 = $6 + $.50

The option premium, or price, consists of two factors, intrinsic value and time value. In this example, the intrinsic value is $6. Intrinsic value is simply another way of saying an option is “in-the-money.”

If you exercised the option today, and then eliminated the resulting stock position from your account, that is how much cash you would collect. Out-of-the-money options have zero intrinsic value. The intrinsic value is immune to time decay.

Calculating intrinsic value is easy. Here is the formula for call options: Stock Price – Strike Price = Intrinsic Value. For example: $91 – $90 = $1 (Stock is $91 and the strike price is $90).

So when you hear option traders say that an option has intrinsic value, it simply means their option is in-the-money.

Time is money

In addition, when pricing options, you also have an important factor called “time value.” This is simply what is left over from the option premium after deducting the intrinsic value. Anyone who buys or sells options knows about the importance of time value. As soon as you buy an option, time becomes your enemy. The closer it gets to expiration, the more rapidly the price deteriorates. (In contrast, if you sell an option, such as when writing a covered call, time is your friend. Option sellers are very comfortable with time deterioration.)

Now, let’s say you’re ready to buy a call option and calculate the intrinsic value of the XYZ option at $1 (for example, $91 stock price- $90 strike price = $1 intrinsic value). There is a month left to expiration and the question is: How much time value should be included in the option premium?

Here’s the intriguing part: when you look at the price of similar options (same stock price, same strike price and expiration date, but a different underlying stock), you discover a wide range of prices. The options appear similar, yet the option prices tell us that something is affecting the premium. That something is the X-factor — volatility.

For instance, the call option for stock A may be trading near $1 when a similar-looking option for stock B may be trading near $4 (or more). Why is the $4 call so expensive? It’s all due to that X-factor.

When a stock has been volatile, or is expected to be volatile due to a pending news announcement, its option prices are higher. That’s because option buyers earn a profit when the stock makes a big move. When such a move is anticipated, buyers pay higher prices (and sellers demand higher prices). When a small stock-price change is anticipated, options are priced much lower.

The option price is swayed by the estimated volatility that is plugged into the option-pricing model used by market makers, who establish bid and ask prices for all options. They use calculators to determine option prices.

Calculating option values requires the use of a complex formula. Fortunately, you can find an options calculator on theChicago Board Options Exchange (CBOE) or Option Industry Council (OIC) Web sites. The calculator is based on the famous Black-Scholes model and is easy to use.

Volatility strategies

Volatility is considered the most important factor when pricing options. Other factors are known, but volatility must be estimated. Yet not everyone uses the same estimate, and that causes options to appear inexpensive to some traders and costly to others.

At a basic level, volatility measures the movement of a stock over a specified time. It is that elusive factor which can cause you to overpay for options and lose money even when correctly predicting both the direction of the underlying stock and the timing.

This common situation is extremely frustrating for the novice trader who does not understand the concept of implied volatility. Too often, the novice pays too much for his or her options and loses money.

Rule No. 1: Do not overpay. Use an options calculator to determine implied volatility. To make the calculation, enter other parameters such as the stock price, strike price, interest rate, dividends, and expiration date, and option type (put or call). The calculator does the rest. Next, decide if you are willing to pay that implied volatility to purchase options (or accept that implied volatility when selling).

In simple terms, implied volatility represents a feeling of urgency that traders have about certain options. More exciting stocks have high implied volatility, and you must pay more. Less-exciting stocks have a lower implied volatility, so they’re cheaper. During volatile markets, implied volatility, and thus option prices, often skyrocket.

There are a number of option strategies that involve volatility. First, you can buy or sell options based on your assessment of current implied volatility.

Second, you can “buy or sell volatility.” In other words, base the trade on profiting from a change in implied volatility, rather than on a change in the stock price. This is a concept used by sophisticated traders.

A basic understanding of implied volatility can help you decide how much to pay for options, and that’s a good tool to have during volatile markets.

Michael Sincere is the author of Understanding Options (McGraw-Hill, 2006) and All About Market Indicators(McGraw-Hill, 2011). Mark Wolfinger writes a daily blog,