by George Angell

There are several factors that affect the overall level of index option prices – the underlying index’s value, the option’s strike price, time until expiration, volatility, interest rates and dividends.

The prices of index calls and puts prior to expiration reflect both intrinsic value and time value.  The most important consideration is the index value compared to the strike price of the option.  This determines whether the option is in- or out-of-the-money.  A call or put that is in-the-money has intrinsic value – the amount the holder would receive upon exercise.  The intrinsic value of a 75.00 strike ABC index call is $2.50 if the underlying index is at 77.50 (77.50 – 75.00 = 2.50).  Similarly, the intrinsic value of a 75.00 strike ABC index put is $3.25 if the underlying index falls to 71.75 (75.00 – 71.75 = 3.25).

The time value of the option consists of the traded price less the intrinsic value.  If a 75.00 strike ABC call is trading at 4-1/4 with the underlying index at 77.50, then its intrinsic value is $2.50 (77.50 – 75.00 = 2.50), and its time value is 1-3/4 (4-1/4 – 2.50 = 1-3/4).  Out-of-the-money options have no intrinsic value and thus their premiums reflect pure time value. 

Index call and put prices are directly related to the amount of time remaining prior to expiration.  Other factors being equal, the longer the period to expiration, the higher the price of the option.  One exception to this may be an ABC deep in-the-money put.

Like the market as a whole, ABC option prices are affected by the level of interest rates.  Other factors being equal, the higher the interest rate, the higher the call price and the lower the put price.

Volatility levels in the market also affect index call and put prices.  Volatility is expressed as an annual percentage such as 15 or 20 percent, which is a statistical measure of how much the market is expected to move in a year.  The amount of volatility in the marketplace, and underlying index in particular, is influenced by many economic and political factors such as investors’ expectations of changes in inflation, unemployment, interest rates, war and technology.  It is important to understand that during any trading day, the consensus among traders and investors on an estimate of future volatility is dynamic and can change frequently and abruptly.

Increases in dividends or the dividend yield of the underlying index generally result in lower call prices and higher put prices.

Volatility

With regard to stock prices and stock index levels, volatility is a measure of changes in price expressed in percentage terms without regard to direction.  This means that a rise from 200 to 202 in one index is equal in volatility terms to a rise from 100 to 101 in another index, because both changes are 1 percent.  Also, a 1 percent price rise is equal in volatility terms to a 1 percent price decline.  While volatility simply means movement, there are four ways to describe this movement:

  • Historic volatility is a measure of actual price changes during a specific time period in the past.  Mathematically, historic volatility is the annualized standard deviation of daily returns during a specific period.
  • Future volatility means the annualized standard deviation of daily returns during some future period, typically between now and an option’s expiration.  And it is future volatility that option pricing formulas need as an input in order to calculate the theoretical value of an option.  Unfortunately, future volatility is only known when it has become historic volatility.  Consequently, the volatility numbers used in option pricing formulas are only estimates of future volatility.  This might be a shock to those who place their faith in theoretical values, because it raises a question about those values.  Theoretical values are only estimates, and as with any estimate, they must be interpreted carefully.
  • Expected volatility is a trader’s forecast of volatility used in an option pricing formula to estimate the theoretical value of an option.  Many option traders study market conditions and historical price action to forecast volatility.  Since forecasts vary, there is no specific number that everyone can agree on for expected volatility.
  • Implied volatility is the volatility percentage that explains the current market price of an option; it is the common denominator of option prices.  Just as p/e ratios allow comparisons of stock prices over a range of variables such as total earnings and number of shares outstanding, implied volatility enables comparison of options on different underlying instruments and comparison of the same option at different times.  Theoretical value of an option is a statistical concept, and traders should focus on relative value, not absolute value.  The term “overvalued” and “undervalued” describe a relationship between implied volatility and expected volatility.  Two traders could differ in their opinion of the relative value of the same option if they have different market forecasts and trading styles.