How are Options’ Prices Structured

Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options

In the previous post I discussed the basics of options. The price of an option is essentially the premium that you pay for the option (whether it be a call option or a put option). Below are the factors that affect the premium (aka option’s price). Obviously, you want the premium to be as cheap as possible, thereby increasing the probability of making a profit on your investment.

Time

Every single option, whether call options or put options, has a time factor. An option will expire on a certain date that’s determined by mutual agreement between the option seller and the option buyer. This time factor also affects the option’s premium.

The premium of an option is based on a simple mathematical formula: the square root of time (how long before the option expires). Thus, as time goes on, the premium you pay (as an option buyer) increases at an ever slowing rate. This right here is the assumption behind options, which is something that you (the option buyer) can exploit.

Keep in mind that the premium is meant to protect the option seller (and hurt you, the option buyer). This basic assumption implies that:

Over the long term, the market is neutral. Gains will be offset by losses, and losses will be offset by gains. Thus, it is ok for premiums to increase at a slowing rate (the slope decreases) b/c the risk also increases at an ever slowing rate.

Thankfully, this assumption is just plain wrong. Or else trends wouldn’t exist! And since we know that (obviously) trends do exist, we can exploit this assumption to our own benefit. For example, commodities have been in a bullish trend over the past 13 years. Whoever sold commodity call options would have lost a lot of money over the last 13 years!

Thus, it is evident that long term options (1 year – 5 year) options relatively speaking become cheaper and cheaper (because time is square rooted). That’s why long term options are generally much cheaper than short term options and why, generally speaking, long term options are much better investments.

Volatility

The definition of volatility is simple: how much has the price of a market been fluctuating recently? The larger the fluctuations, the higher the volatility. The smaller the fluctuations, the lower the volatility.

The second component that affects an option’s premium (besides the time until expiration) is volatility. This is actually quite simple to understand – the more volatile prices are recently, the higher premium you (as the option buyer) will be required to pay. The smaller volatility has recently been, the lower the premium you will pay. Why?

Because from a pure theoretical risk management standpoint, volatility = risk. The theorists assume that present low volatility will result to future low volatility. In other words, they extrapolate the present low volatility into the future. We’ll see why that is not true in reality.

Theoretically speaking, low volatility equals to low risk to the option seller. Thus, options are cheap to buy when volatility is low. However, volatility is usually lowest (option premiums are cheapest) near the end of a bull market, when every person out there is a blindly bullish (a.k.a. the market is in a bubble). Thus, in reality low volatility actually equals high risk. When volatility is low, you know that the market is in a bubble and sooner or later, the bubble is going to burst and all the bulls are going to be in a ton of pain.

Thus, the time when volatility is low and options are cheap is exactly when risk is the greatest. Low volatility does not equate to small risk. It equates to large risk (because the bubble is about to burst).

The most common measurement of volatility if VIX, an index created in 1985. Its sole purpose is to measure the amount of “fear” or “volatility” in the market.