Papale on Risk Perception

By Steve Papale

I was in a bookstore the other day browsing the discount bin when I noticed a book on strange and unknown facts.  I picked it up and lo and behold I read a strange and unknown fact (at least to me).  It seems a little too crazy to be true but it is at least worth a mention.  It is said most people got married in June because they took their yearly bath in May and still smelled pretty good by June. However, they were starting to smell so brides carried a bouquet of flowers to hide the body odor. Hence the custom today of carrying a bouquet when getting married.   Then I thought what if the bride assumed this but in fact the groom had his yearly bath in July?

There are two main drivers of options prices – the actual movement of the underlying and the expectation of movement in the underlying between now and expiration.  One is reality and one is perception.  This perception or expectation of risk going forward in time shows up as time premium or extrinsic value.  This extrinsic value moves up and down, almost breathes based on the changing perception of risk in the underlying.

For example, earnings represents uncertainty for stocks.  Because of the greater level of uncertainty, option prices get bid up.  Options are essentially insurance policies.  When the risk of an adverse event goes up – the cost of insuring against that event goes up as well.  I learned this when my 16 year old got his driver’s license.  He’s as safe as any 16 year old with 6 months of experience.  But from the perspective of the insurance company it is uncertain whether he turns out to be a safe driver (desired) or an unsafe driver(adverse).  Time and experience will bear that out and his cost of insurance will reflect that accordingly.  Same in the options markets.  Higher perception of uncertainty means it’s less clear if markets will rally (desired) or fall (adverse).   Once the uncertainty is removed and the stock moves, the premium in option prices nearly always comes down.  If the desired outcome is achieved (the stock rallies) this premium can come down a lot.  If the adverse event happened and the stock dropped, the premium can still fall if the markets believe there is no more adverse movement left to come.  Time premium or extrinsic value is always a function of risk perception in the future.

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