Two stocks with options which are about the same price are not always equal. Volatility is one of the reasons two stocks with a similar underlying price may actually have very different values for their options. Volatility can be a useful tool to determine which underlying you would like to trade.
The level of volatility can also help to determine the type of strategy you may want to use to possibly increase your odds of obtaining a profit. Please refer to the previous article I wrote to see different strategies which can be traded when volatility is higher or lower.
Volatility measures how risky the underlying stock is in regards to uncertainty or how much it moves in price. Volatility is sometimes difficult to determine, and is the one part of the option pricing model which can vary the most.
When an underlying stock has higher volatility, you can expect a greater move in either direction. Higher volatility can also lead to a higher price for both put and call options, which will be noticed mostly with the at-the-money options. There is the most uncertainty with the at-the-money options, so there is more volatility.
The extrinsic value is higher with options with higher volatility when comparing two similarly priced underlying. The extrinsic value of an option is the time portion of the option. The extrinsic value is highest with the at-the-money options. As you move further in the money or out of the money, the extrinsic values decrease.
Let’s Compare Two Similarly Priced Stocks
GLD and FB have about the same underlying price. GLD is currently trading at 102.20 and has a volatility of 14.10%. FB is currently trading at 106.92 with a volatility of 27.18%. FB has higher volatility, whereas GLD has lower volatility. GLD, has lower volatility and will have lower priced options than FB, the higher volatility stock with options.
The difference in volatility of the two stocks will be reflected mostly in the extrinsic value of an option’s price.
Extrinsic value is determined by taking the price of an option and subtracting its' intrinsic value.
To explain extrinsic value, we must first discuss intrinsic value.
In-the-money options have intrinsic value. Intrinsic value is determined for a call option by taking the current stock price minus the strike price. With a put option, the intrinsic value is determined by taking the strike price minus the current stock price.
Take a look at Figure A which is below. GLD stock price is 102.201. Now take the Jan 16 100 strike call option and subtract it from the current stock price of 102.201 (102.201 minus 100 equals 2.201). Therefore, the Jan 16 100 strike call option for GLD has an intrinsic value of 2.201. This is the amount the Jan 16 100 strike call option is in the money, or the intrinsic value. The bid/ask spread of the Jan 100 call strike for GLD is 2.68 to 2.73. If you average the bid/ask spread, you get the value of the call to be 2.705. So the GLD Jan 16 calls are trading for about 2.705. Since the option’s current value is 2.705, then 2.201 of the option premium is the intrinsic value.
Figure A: GLD Option Chain Intrinsic/Extrinsic Values/ Volatility @ 14.10%
Next, let's review extrinsic value
As stated previously, extrinsic value is determined by taking the price of an option and subtracting its' intrinsic value. Look at Figure A again. The price of the Jan 100 call option we determined to be approximately 2.705. The intrinsic value we determined to be 2.201. Take 2.705 minus 2.201 and you get .504, which is the extrinsic value of the option.
Now let's look at FB Jan 16 Option Chain in Figure B below……
Figure B: FB Option Chain Intrinsic/Extrinsic Values/ Volatility @ 27.18%
Both GLD and FB are trading at about the $105.00 level. The volatility for FB is 27.18%, which is higher than the GLD volatility level of 14.10%. So you would expect the option price to be higher for FB than GLD. Let’s take a look and see if this is true. The January 105 call option strike price for FB is about 3.40. The 105 call option strike price for GLD is about .345. As you can see, there is a large difference between the values of the two options. The higher volatility of FB makes the value of the 105 call option much more than the value of the GLD 105 call option.
The volatility of the underlying affects the pricing of the options. In these two examples, the market makers are pricing in more premium for the FB options because it is more volatile. The market makers are factoring in more extrinsic value, or time premium, because FB is more volatile than GLD.
It is important to track and be aware of the levels of volatility of the underlying stocks you trade.
If you are looking at two stocks with an underlying price about the same, you may think the options would be priced about the same. This many times is not true. It is important to look not only at the stock price of an underlying, but also the volatility. The above examples illustrate how two stocks trading at about the same price can have option values that are quite different.
I hope this helps you in your trading decisions.
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