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The Option Premium and Its Components

The premium—the cost of the option—is going to vary over time based on three factors: time to expiration, volatility, and intrinsic value.

Time to Expiration

The longer the time until expiration, the higher the “time value” of the option. Time value tends to change very little for exceptionally long-term options. For example, for a LEAPS (long-term equity anticipation securities) option, which may have as much as 30 months to expiration, changes in the underlying stock’s price have little or no effect on the time value. As time approaches expiration, however, the rate of decline in time value premium accelerates. At the point of expiration, time value will have declined to zero.

The tendency for time value to accelerate as expiration approaches affects the decision about when to buy or sell an option, especially for those trading short positions (selling options). The majority of long options are not going to become profitable, mainly due to the declining time value. However, short options traders know that time value creates profits. As time value evaporates, the option loses premium value. And because short traders go through the sequences of sell-buy-hold instead of the opposite, reduction in value equals profits. So the short trader sells to open, and then when value has fallen, buys to close at a lower premium level. This is where time value works for the seller.

Volatility

The most elusive and hard to understand part of premium value is due to the level of volatility in the underlying stock. This volatility is an expression of market risk. Stocks with relatively narrow trading ranges (the distance between highest and lowest price levels) are less risky, but they also offer less opportunity for profits in the stock or in options. Stocks with broad trading ranges and rapid changes in price are high-risk but also offer greater profit opportunities. The option premium level is directly affected by this price volatility. The level of unpredictability in a stock’s current and future price level defines an option’s premium value.

Some analysts include this volatility effect as part of time value, but this only confuses the analysis of options. Time value by itself is quite predictable and, if it could be isolated, would be easily predicted over the course of time. Simply put, time value tends to change very little with many months to go, but as expiration nears, the rate of decline in time value accelerates and ends up at zero on the day of expiration. But time value cannot be separated from the other elements of value, so it is often seen as part of the same price feature. Time/volatility value is often described as a single version of “time value premium.” If these two elements are separated, option analysis is much more logical.

The portion attributed to volatility might be accurately named “extrinsic value.” This is the portion of an option’s OTM premium beyond pure time value. Extrinsic value can be tracked and estimated based on a comparison between option premium trends and stock volatility.

To understand how volatility works for the underlying stock, a few technical tools are required. The trading range is easily quantified for most stocks. If you study and compare stocks, you discover that trading ranges vary considerably. The greater the breadth of the range, the more extrinsic value you find in option premium. Even so, the most popular version of price volatility is far from accurate. To accurately track and predict extrinsic value, you need to adjust the method for calculating volatility for the underlying stock.

In its most common definition, price volatility is calculated by mathematically reviewing the price range over the past 52 weeks and then assigning a percentage to the range. For example, if the stock’s range has been between 27 and 34 points, volatility is 26 percent. The calculation requires dividing the net price difference by the low, as follows:

  • (34 − 27) ÷ 27 = 26%

This seven-point price range is really quite narrow when you consider what can happen over a period of 52 weeks. Now consider how those seven points change in terms of volatility when the price range is between 85 and 92:

  • (92 − 85) ÷ 85 = 8%

The same seven-point price spread has been reduced to an eight percent volatility level, even though the price range is the same.

Another problem with volatility is that it does not distinguish between rising and falling price trends. One stock might experience a 52-week range but currently reside at the low end. Another with an identical price range might currently be valued at or near the top of that range. This price trend also affects the value of options at various strikes.

Finally, the price range does not allow for the occasional price spike. In statistics, one principle required to arrive at an accurate average is to exclude any unusual spikes in a field of values. This should apply to stock prices as well, but the adjustment is rarely made. For example, a review of Yahoo! (YHOO) at the end of August 2008 showed a 52-week price range from 18.58 to 34.08. The volatility was 83%, as follows:

  • (34.08 − 18.58) ÷ 18.58 = 83%

However, this price range includes a spike up to the top of 34.08 when Yahoo! was negotiating with Microsoft, and rumors were that the Microsoft offer might be made at that highest level. Negotiations fell apart, and the price retreated. If you exclude this one-time price spike, the trading range was closer to 18.58-30.00. In this situation, volatility is reduced considerably:

  • (30.00 − 18.58) ÷ 18.58 = 61%

Applying a basic statistical rule that spikes should be removed, the volatility for this company would be far lower than with the spike included. The definition of a spike is that it takes price above or below the trading range and that following the spike, prices return to the normal range without repeating the spike again.

The unreliability of the typical method for computing volatility should be discounted. To select options based on volatility, it is first necessary to develop a more comprehensive method for the basic calculation. This includes consideration of the following:

  1. Price spikes, requiring adjustment of the 52-week range.
  2. Changes in the breadth of the trading range over time (a changing trading range implies increases in volatility, which is likely to affect future premium value).
  3. The number of points in the range compared to the stock price itself. For example, a seven-point trading range for a stock trading in the mid-20s is more significant than a seven-point trading range for a stock trading in the high 80s. Although this point spread varies in significance based on stock price, its effect on option premium is what really matters. Thus, the analysis of the point count should also track the trend from the beginning to the end of the one-year range.

Determining the level of extrinsic value (or, volatility value) requires considerable technical analysis of the stock’s price and its trend. No current value should ever be studied as fixed in time, but rather takes on meaning when its change is part of the analysis. The trend affects recent changes in option extrinsic value and may also point to how that trend is going to continue to change in the future.

Intrinsic Value

The final portion of the option’s premium is the most easily explained and understood. Intrinsic value is that portion of the premium attributed to in the money (ITM) status of the option. When an option is at the money (ATM), meaning strike is equal to stock price, there is no intrinsic value. When the option is OTM, meaning call strike is higher than current stock price or put strike is lower than current stock price, there is no intrinsic value. The only time intrinsic value exists is when the option is in the money (ITM).

For example, a call has a strike of 60 and the current stock price is 62. This option has two points of intrinsic value, worth $200. Each change in the stock’s price will be matched by change in intrinsic value, down to the strike and upward indefinitely.

For a put, the movement is opposite. For example, a put has a strike of 45, and the stock price is currently at 42. There are three points of intrinsic value. So if this put’s premium is reported today at 4.50, that consists of 3.00 points in intrinsic value and 1.50 points in some combination of time and extrinsic value. Like the call, the put’s intrinsic value moves point for point with the stock. As the stock’s price declines, the put’s intrinsic value rises; and as the stock’s price rises, the put’s intrinsic value falls.

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