How to Value an Option — Part II

Last week we looked at how to value an option. If you recall, there are two basic components that combine to give you the value of an option — intrinsic value and time value.

Intrinsic value represents how much an option is in-the-money if you exercise it right now. For example, if a share is trading at $5.50, then a call option with a $5 strike price has 50 cents of intrinsic value. Or, if a share is trading at $10, then a put option with a $12 strike price has $2 of intrinsic value.

Time value represents that part of the option price (premium) beyond its intrinsic value. If an option is trading at 40 cents and has 30 cents of intrinsic value, then the time value is 10 cents. If an option doesn’t have any intrinsic value, then all of an option’s price is made up of time value.

The more time the option buyer has to ‘right’, the more they are prepared to pay for the option. And, the more time in which the option writer is exposed to being exercised, the more premium they will want to receive.

Apart from these basic components, there are a number of other factors that influence the price of an option.

Volatility of the underlying shares

Let’s consider two very different companies. One is a resource company that has a history of earnings surprises and wild price swings. It only produces one commodity, so any big price moves in that will greatly affect the share price.

The other is a utilities company with a history of steady earnings and moderate growth. The share price doesn’t move around much and it pays regular dividends to its shareholders. Both shares currently trade at similar prices.

You are looking to sell an option with the same time until expiry and at the same strike price. Would you expect to receive the same option premium for both companies?

Undoubtedly, you’ll want to receive more for selling the option in the more volatile stock. That is, the resources company. As it’s more volatile than the utilities company, there is a higher probability that your option will be exercised before expiry.

Volatility measures how rapidly the price changes in the underlying security. The more it moves, the higher its volatility. And the more premium the option seller will want to receive. The rate at which the option price moves in relation to the underlying share price is called its ‘delta’.

As volatility plays such big part in the time value of an option, there is a basic rule to learn. As an option buyer, you want to buy options with low volatility. As an option writer, you want to sell options with high volatility.

Sometimes you’ll see this referred to as buying or selling volatility. Volatility plays as much of a role in the option pricing as does the time until expiry.

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Another factor that will affect the price of an option is a dividend. It’s the owner of the physical shares as at the record date who is entitled to receive the dividend, not the option owner. Until an option is exercised and the trade ‘settled’, no change in legal ownership takes place.

In theory, a stock price should drop on the ex-dividend date (the day at which shares trade without entitlements to the dividend) by the same amount as the dividend. Option prices need to reflect this scenario.

If a share is due to receive a dividend before an option expires, then a call option premium will be lower. First, the call option buyer misses out on the dividend (unless they exercise the call option early). Second, the option price needs to allow for the drop in the share price when it goes ex-dividend.

As a dividend affects a put option too, the option price needs to reflect this. If you are going to sell a put option over a share that is going ex-dividend, you need to allow for the fall in the share price. So, you’ll expect to receive a larger premium.

One thing to be aware of is early exercise. A call option buyer may choose to exercise an option early so that they can participate in a dividend. You need to check if a stock is going ex-dividend before you sell a call option over it.

Interest rates

Another factor affecting the value of an option are interest rates. Call option premiums will typically increase as interest rates rise, and vice versa. Put options will typically decrease in value as interest rates rise, and vice versa.

If option prices didn’t reflect interest rates, then the advantage would be with the option buyer. To understand the impact of interest rates you need to think about the difference between buying a call option and buying the stock outright.

If option prices didn’t allow for interest rates, an investor could buy a call option (at a fraction of the cost of buying the shares outright) and park the rest of their funds in a term deposit and reap the benefits of a high interest rate.

In effect, it would be a free ticket to the option buyer. They could enjoy the upside (if the share price increases) via the call option, whilst earning interest on their funds held in the bank. Another way to look at it is simply through the view of opportunity cost. The more interest rates go up, the more you gain by putting off your purchase. You receive interest income in the meantime, while not needing to tie up your funds by buying the shares outright.

The opposite applies to put options. If you just sold shares outright, you only need to wait for settlement (T + 3) before you start earning interest on your funds. A put option is effectively delaying the sale, so you’re missing out on receiving interest until exercising the option.

The higher the interest rate, the more interest income you’re giving up by buying and holding the put option instead of selling your shares. So, the less the put option buyer is prepared to pay in premium.

Corporate actions

If there are any changes to the structure of the underlying shares then the options need to reflect this. The main rule here is that any changes to the company structure must be pro-rata — that is, it affects all shares proportionally.

For example, if a company did a share split on a 1:5 basis, then the options need to reflect this. One $10 call option contract would be adjusted to five $2 call options. The aim is always that neither the option buyer nor seller will be adversely affected by the change. It needs to be fair to both parties.

As you’ve read, there are many factors that can influence the price of an option. Intrinsic and time value, along with volatility are all important factors. However, other factors such as interest rates impact on the price. Finally, before undertaking any option trade, always check to see if it’s due to go ex-dividend before option expiry.

Matt Hibbard,

Editor, Options Trader

Editor’s note: The above article was first published in Money Morning.

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Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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