Last updated on July 14th, 2022 at 03:06 pm
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Option volatility is ultimately dictated by supply and demand in the market for the underlying security on which the option is based. Buyers and sellers are more likely to transact on options with high levels of implied volatility because they are the financial instruments most likely to positively payout for their owners.
Some call/put options are so expensive due to their premium value, which is mainly determined by their implied volatility (how volatile the stock is believed to be). Put options are usually more expensive than call options as well.
Any option’s expensiveness versus others is defined by the expected uncertainty of its underlying asset.
For example let’s say ABC stock seems to always trades for between $25-$30 and rarely breaks out of the that range throughout the year. That stock would have much lower premiums than a stock that has swings widely between $20-$50 as the calls or puts could easily be more valuable so in turn they are more expensive.
Read on to learn more about option value and the power of implied volatility.
Implied Volatility Ultimately Controls Option Pricing
Options are financial instruments that let investors bet on the near-term price movement of an underlying security and give the “option” to execute at a strike price for a profit – if the bet goes their way.
Fees and premiums determines an options overall costs.
Option fees are relatively uniform across brokerage firms nowadays, either being free to trade or a small percentage charge of the total investment. As the bulk of an option’s cost, premiums are determined by the current market value of a given option contract.
Understanding Option Values
Option values are made up of a few distinct factors. Though there are different models for pricing options, one of the most popular is the Black-Scholes Model.
To summarize its complexity, its primary components to determine an option’s value are as follows:
- Time and interest rate
- Intrinsic value
- Implied volatility
The time to the option’s maturity and market interest rate are significant drivers of an option’s general value, one defined by the contract and the other determined by the overall market and its current risk-free rate.
The intrinsic value is the difference between the call or put option’s strike price and the current price of the underlying asset. This value is what a trader could make if they sold the option right now, just as long as it’s “in the money” – or the underlying is trading at a favorable price versus the strike.
“Out of the money” options have no intrinsic value.
However, implied volatility is arguably the most crucial factor in determining an option’s value.
Implied volatility (IV) is the primary determinant of an option’s relative level of expensiveness versus other options in the market. This is perhaps because option traders hunt for high IV options, increasing their demand and, thus, their price.
According to Options Trading Beginner, IV is the best way to tell if an option is over or underpriced currently.
Based on the nature of how options inherently work – i.e., you make more money from larger movements in underlying stock prices – volatility is, therefore, a significant factor in option valuation.
In general, the more volatile a security is expected to be within the contract period, the more expensive the option price will be. This is because the higher the implied volatility of a given security, the more likely its options are to be “in the money” at the point of maturity.
To sum this into simpler terms: the more an asset’s price is likely to swing chaotically, moving from a low to high price, or vice versa, the more likely the cost is to pass over a given strike and the more attractive and pricier options around that asset will become.
Of course, all option costs and levels of volatility are relative. Thus, an option’s expense being over or underpriced will always be determined by similar options around the same or similar securities currently trading in the market.
Historical volatility is another helpful metric in understanding implied volatility and the relative nature of a given stock or its options.
Put Options Are More Expensive Than Calls Due to Volatility, and Supply and Demand
With volatility being the primary factor for option valuations, what might account for the price difference between call and put options?
According to The Balance, even when the intrinsic or extrinsic value (or the difference between an option’s strike price and the current price of the underlying, positive or negative) are equal between a given call and put option – put options consistently sell for higher premiums.
This is because put options are more expensive than call options.
Why might this be?
The answer partly has to do with volatility skew, or the different implied volatility values for “in” or “out of the money” put options versus calls.
Additionally, the price difference is due to historical trader supply and demand. For “out of the money” call options, demand is rarely as high as it is for their put option counterparts.
The Balance goes on to point out the fact that put options have a higher “delta,” or exposure to risky price changes in the underlying asset. While “out of the money” put options are more likely to expire worthless in the market, on average, than call options – when they are purchased and end up “in the money,” the payout can be huge!
Historically, far “out of the money” put options have bigger potential payouts than call options. Steep market falls and crashes can make such puts become like “jackpot” winners.
Thus, to price in the slim bit highly profitable chance of a jackpot, the market makers in charge of setting premiums and creating option contracts in the finance world have set put options to command a higher price than call options.
On a related note: in the long run of the market, since stocks are likely to rise over time – and put options are a bet against an individual asset’s price increasing – they are typically riskier and more volatile than call options.
However, the smaller the time frame for an option contract, the more equalized the risk becomes between trading with a put or call option.
Option values are driven by volatility. The more volatile a given option is, the more likely its premium is to be high. Expensive premiums could mean that an investor is more likely to overpay to hold such an option.
However, given the potential efficacy of the efficient-market hypothesis, perhaps option costs – like put option costs being higher than calls – are simply warranted by the market’s supply and demand curve.
All costs are relative. By purchasing “expensive” options, a trader may just be buying themselves a better opportunity to turn a profit on a more volatile underlying asset.