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Knowledge Corner

Implied Volatility & valuation of Option Premium - OVERVALUED or UNDERVALUED?

Factors determining option price

The value of an option depends basically on the supply & demand, the underlying price of the asset but most importantly there are many other factors that influence the price of options which is the price the buyers are ready to pay or the sellers are ready to sell at. Factors such as Intrinsic Value, Time Value, Underlying Price, Strike Price, Time to expiration, Risk free rate, and Volatility are discussed below in detail and these factors persuades the price of an option to a great extend.

1) Intrinsic value of an option

Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. In other words, the intrinsic value of an option is the amount the option is in-the-money (ITM). If the option is out-of the- money (OTM), its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0, (St — K)] which means that the intrinsic value of a call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max [0, K — St] i.e., the greater of 0 or (K — S t) where K is the strike price and S t is the spot price.

2) Time value of an option

In addition to the intrinsic value, the seller charges a ‘time value’ from the buyers of the option. This is because the more time there is for the contract to expire, the greater the chance that the exercise of the contract will become more profitable for the buyer. This is a risk for the seller and he seeks compensation for it by demanding a ‘time value’. The time value of an option can be obtained by taking the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is Out-of-the-money (OTM) or At-the-money (ATM) has only time value and no intrinsic value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else being equal. At expiration, an option has no time value.

3) The underlying price

Call and Put options react differently to the movement in the underlying price. As the underlying price increases, intrinsic value of a call increases and intrinsic value of a put decreases. Thus, in the case of a Call option, the higher the price of the underlying asset from strike price, the higher is the value (premium) of the call option. On the other hand, in case of a put option, the higher the price of the underlying asset, the lower is the value of the put option.

4) The strike price

The strike price is specified in the option contract and does not change over time. The higher the strike price, the smaller is the intrinsic value of a call option and the greater is the intrinsic value of a put option. Everything else remaining constant, as the strike price increases, the value of a call option decreases and the value of a put option increases. Similarly, as the strike price decreases, the price of the call option increases while that of a put option decreases.

5) Time to expiration

Time to expiration is the time remaining for the option to expire. Obviously, the time remaining in an option’s life moves constantly towards zero. Even if the underlying price is constant, the option price will still change since time reduces constantly and the time for which the risk is remaining is reducing. The time value of both call as well as put option decreases to zero (and hence, the price of the option falls to its intrinsic value) as the time to expiration approaches zero. As time passes and a call option approaches maturity, its value declines, all other parameters remaining constant. Similarly, the value of a put option also decreases as we approach maturity. This is called “time-decay”.

6) Risk free rate

Risk free rate of return is the theoretical rate of return of an investment which has no risk (zero risk). Government securities are considered to be risk free since their return is assured by the Government. Risk free rate is the amount of return which an investor is guaranteed to get over the life time of an option without taking any risk. As we increase the risk free rate the price of the call option increases marginally whereas the price of the put option decreases marginally. It may however be noted that option prices do not change much with changes in the risk free rate.

7) Volatility

Volatility is a very important factor in the price of an option. Volatility is defined as the uncertainty of returns. The more volatile the underlying higher is the price of the option on the underlying. Whether we are discussing a call or a put, this relationship remains the same. Whether one is planning to purchase a put or call option, it pays to know more than just the impact of a move of the underlying on ones option's price. Often option prices seem to have a life of their own even when markets move as anticipated. A closer look, however, reveals that a change in implied volatility is usually the culprit. While knowing the effect volatility has on option price behavior can help cushion against losses, it can also add a nice bonus to trades that are winning. The trick is to understand the price-volatility dynamic - the historical relationship between directional changes of the underlying and directional changes in volatility

Implied Volatility

A theoretical value designed to represent the volatility of the security underlying an option as determined by the price of the option. The factors that affect implied volatility are the exercise price, the riskless rate of return, maturity date and the price of the option. Implied volatility appears in several option pricing models, including the Black-Scholes Option Pricing Model.

Implied volatility represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately. Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. Options that have high levels of implied volatility will result in high-priced option premiums. Conversely, as the market's expectations decrease, or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices. This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option. The goal of most traders is to buy undervalued options and sell overvalued options. IV helps to figure out which options are undervalued or overvalued.

How Implied Volatility Affects Options

The success of an options trade can be significantly enhanced by being on the right side of implied volatility changes. For example, if you own options when implied volatility increases, the price of these options climbs higher. However, a change in implied volatility for the worse can create losses, even when you are right about the stock's direction.

Short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This is based on the fact that long-dated options have more time value priced into them, while short-dated options have less. Each strike price will respond differently to implied volatility changes. Options with strike prices that are near the money are most sensitive to implied volatility changes, while options that are further in the money or out of the money will be less sensitive to implied volatility changes. An option's sensitivity to implied volatility changes can be determined by Vega - an option Greek. Keep in mind that as the stock's price fluctuates and as the time until expiration passes, Vega values increase or decrease, depending on these changes. This means that an option can become more or less sensitive to implied volatility changes. Implied volatility fluctuates the way price do, implied volatility is expressed in percentage terms and is relative to the underlying stock and how volatile it is. One cannot compare implied volatility of two stocks because each stock would have different range of implied volatility movement. What might be considered as lower percentage value for one stock might be considered as relatively high for another.

Implied Volatility Cycle – Buying Undervalued & Selling Overvalued Options

Implied volatility, like everything else, moves in cycles. High volatility periods are followed by low volatility periods, and vice versa. Using relative implied volatility ranges, combined with forecasting techniques, helps investors select the best possible trade. When determining a suitable strategy, these concepts are critical in finding a high probability of success, helping you maximize returns and minimize risk. One should look at the peak and troughs of implied volatility to determine when the underlying options are relatively cheap or expensive.

Example: Implied volatility strategy can be used by traders to sell peaks of implied volatility (i.e.) when implied volatility is at its peak of its range for that particular option then the option premium is considered overvalued and the premium can be sold expecting implied volatility to drop which causes a fall in option premium. On the other side implied volatility troughs can be used to buy options expecting the option implied volatility to move higher forcing the option premium to raise. When you discover options that are trading with low implied volatility levels, consider buying strategies. With relatively cheap time premiums, options are more attractive to purchase and less desirable to sell. The assumption behind the strategy is that the Peaks and troughs of Implied volatility would reverse back to mean.

An elaborated view on the impact of price and volatility changes on options is dealt below to show what strategy should be used be in a particular market scenario of implied volatility in trading the right option. The following should be taken care when adopting the above strategy.

- Make sure you can determine whether implied volatility is high or low and whether it is rising or falling. Remember as implied volatility increases, option premiums become more expensive. As implied volatility decreases, options become less expensive. As implied volatility reaches extreme highs or lows, it is likely to revert back to its mean.
- There could be a reason why options yield high premium due to high implied volatility. So a prudent trader should be checking out new flows about the company which is causing high company expectations and high demand for the options. Because this is when a lot of price movement takes place, the demand to participate in such events will drive option prices price higher/lower as the case may be. Keep in mind that after the market-anticipated event occurs, implied volatility will collapse and revert back to its mean.

The Impacts of Price and Volatility Changes on Options

The table below summarizes the important dynamics of this relationship, indicating with "+" and "-" signs how movement in the underlying and associated movement in implied volatility (IV) each impacts the four types of outright positions. For example, there are two positions that have "+/+" in a particular condition, which means they experience positive impact from both price and volatility changes, making these positions ideal in that condition: Long puts are affected positively from a fall in Nifty but also from the corresponding rise in implied volatility, and short puts receive a positive impact from both price and volatility with a rise in the Nifty, corresponding to a fall in implied volatility.

Positions | Price-Volatility Dynamic | Price-Volatility Dynamic |
---|---|---|

Rise in Nifty/ Fall in IV | Fall in Nifty/ Rise in IV | |

Long Calls | +/- | -/+ |

Long Puts | -/- | +/+ |

Short Calls | -/+ | +/- |

Short Puts | +/+ | -/- |

Impact of Price and volatility changes on long and short option positions. A “+” mark indicates positive impact and a”–“mark indicates a detrimental impact. Those market with “+/+” indicate the ideal position for the given market condition.

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