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 incorporate into your trade plan.
The level of volatility can also help to determine the type of strategy you may want to use to possibly increase your probabilities of obtaining a profit.
Volatility measures how risky the underlying stock is in regards to market uncertainty or how much it moves in price. Volatility can sometimes be 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.
Before I get into an example of how volatility levels can affect the prices of options, let's review the definition of intrinsic and extrinsic value of options. On August 17, 2018, we published an article on this subject; the article can be found here: https://aeromir.com/00182/what-are-intrinsic-and-extrinsic-option-values
To summarize the article:
The Intrinsic Value of an option is the price the underlying is currently trading minus the strike price. If the value which is calculated is a negative number, then the intrinsic value is zero.
The Extrinsic value of an option is many times referred to as “the time value”. The time value is one of the primary elements which affects the premium of an option. The formula to determine the extrinsic value of an option for both the calls and the puts, is:
Current option price minus the Intrinsic value = Extrinsic Value.
The extrinsic value is higher in options with higher volatility when comparing two similarly priced underlyings. 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 look at an example on two underlyings that have similar prices:
GLD and DATA have about the same underlying price. GLD is currently trading at 122.42 and has a volatility of 8.93%. DATA is currently trading at 121.86 with a volatility of 34.21%. DATA has higher volatility, whereas GLD has lower volatility. GLD, with lower volatility, will have lower priced options than DATA, 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. As I mentioned in the summary of the article published last August, extrinsic value is determined by taking the price of an option and subtracting its' intrinsic value.
In-the-money options have intrinsic value. Remember that 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 122.42. Now take the 31 May 120 strike call option and subtract it from the current stock price of 122.42 (122.42 minus 120 equals 2.42). Therefore, the 31 May 120 strike call option for GLD has an intrinsic value of 2.42. This is the amount the 31 May 120 strike call option is in the money, or the intrinsic value. The bid/ask spread of the 31 May 120 call strike for GLD is 2.65 to 2.70. If you average the bid/ask spread, you get the value of the call to be 2.675. So the GLD 31 May 120 calls are trading for about 2.675. Since the option’s current value is 2.675, then 2.42 of the option premium is the intrinsic value. So most of the premium in the calls is 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 31 May 120 call option we determined to be approximately 2.675. The intrinsic value we determined to be 2.42. Take 2.675 minus 2.42 and you get .255, which is the extrinsic value of the option.
Now let's look at DATA 31 May Option Chain in Figure B below……
Figure B DATA Option Chain Intrinsic/Extrinsic Values/ Volatility @ 34.21%
Both GLD and DATA are trading at about the $122.00 price level. The volatility for DATA is 34.21%, which is higher than the GLD volatility level of 8.93%. So you would expect the option price to be higher for DATA than GLD.
Let’s take a look and see if this is true. The 31 May 122 call option strike price for DATA is about 3.40 (average of the bid/ask). The 122 call option strike price for GLD is about 1.16. As you can see, there is a large difference between the values of the two options. The higher volatility of DATA makes the value of the 122 call option much more than the value of the GLD 122 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 DATA options because it is more volatile. The market makers are factoring in more extrinsic value, or time premium, because DATA 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 is not true many times. 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.
Hope this helps you in your trading decisions.
Feel free to leave a comment below.