Papale on Option Value

When I was a kid there were about three Christmas specials.  My brother and I would carefully check the weekly TV guide in the newspaper every Sunday around this time of the year to make sure we did not miss when they were on.    They were on one time.  Period.  If we missed them that was it until next year.  The other night the classic “A Charlie Brown Christmas” was on.  Knowing everyone in our family still loves this classic I told everyone to rally around the TV at whenever time it was on.  Maybe a little family bonding time I thought.  Sorry dad.  Everyone has plans.   Record it.  Plus it will be on another 10 times it seems.  Ah…the options kids have today.

In options, when we talk about “expensiveness” we refer to the implied volatility or IV, not necessarily to the price.  An option with an IV of 20% is said to be more expensive than an option with an IV of 15%, even if the option with the 15% IV has a higher price.  The price of options is made up of intrinsic and extrinsic value.

The intrinsic value is how much the option is in the money.  A 90 call on a stock that is trading at $100 has an intrinsic value of $10.  To an option trader this means nothing.  It’s value moves in line with the price of the stock and has no bearing on the level of IV.

The extrinsic value is what is affected by changes in IV and what dictates how expensive an option is to option traders.   This value moves independent of stock price,  driven by changing levels of fear in the market.   By focusing only on IV options traders are able to compare options across strikes and months, normalizing the effects of strike price and time.  By doing this we can compare an in the money call trading at $10 with a call in a different month that is out of the money that might be trading at $8.  If the $8 option has an IV of 15% and the $10 option has an IV of 12%, the $10 option is cheaper, regardless of trade price.  Don’t get caught up in the actual price of an option.  Focus on the IV instead.

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