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Why Are Some Options So Expensive?
Plenty of people have begun trading options in recent years, and it can be an incredibly lucrative alternative to trading stocks when done right. But, there is an abundance of complexities around option pricing when compared to the simplicity of the pricing of other common trading assets, such as stocks or EFTs.
Some options seem expensive relative to their underlying stock price.
So, why are some options so expensive?
The price of options depends on many variables. Options can be unusually expensive when the time value until expiration is lengthy, unpredictable events exist, such as upcoming earnings announcements, or when volatility is unusually high.
Determining whether different options are worth the price can be incredibly tricky, with all the various considerations and influences. Join us as we discuss options, their pricing, and how to ensure you get the most out of your option choices.
How Do You Know If An Option is Overpriced?
We must go back to the basics to determine if an option is overpriced.
Options are contracts that allow buyers to either sell or buy securities by a specific day at a predetermined price (known as the strike price).
All options derive their value from the underlying security or stock’s value or price, and the variables related to that security.
An equity call option buyer would benefit if the underlying stock price is higher than the strike price by the expiry date. A put option buyer would benefit if the underlying stock price is lower than the put option strike price by the expiry date.
It all depends on the motives of the buyer and the type of option. However, buyers can use a few basic factors to determine whether the price is suitable.
We do not deem overprice or underprice options against a fixed currency value. We consider the price of options against the implied volatility, time value and decay, and intrinsic versus extrinsic value, which are all greatly influential for profitability.
Intrinsic Value
The intrinsic value reflects how much the premium comprises the difference between the current stock price and the strike price. To calculate the intrinsic value, the investor would need to subtract the option strike price from the current stock price.
Determining the intrinsic value is very important to understand whether the pricing is appropriate or if an option is overpriced. If the option is predominantly comprised of intrinsic value (due to time value decay), the value and profitability of the option would be more dependent on the movements and fluctuations of underlying stock prices.
Measuring the option’s sensitivity is done by determining delta, which can be represented as a positive or negative figure, depending on the option type. It will show how much that option’s value will increase or decrease according to fluctuations in the security or stock.
Extrinsic Value
We otherwise known extrinsic value as time value. It is determined by the time remaining before the option’s expiry. This amount is the portion of the option’s premium above the intrinsic value.
The more time that remains before the option’s expiration date, the more time value is embedded in the option’s premium. The buyer will pay more for the advantage of owning that option for a longer time, as there will be a higher probability the underlying security will increase in value over a longer time frame than a shorter time frame.
Option contracts would lose around one-third of the time value during the first half of the time. The extrinsic value decreases at a sped up rate, known as time decay, and it will eventually reach zero as the expiry draws closer.
Volatility
Vega, otherwise known as implied volatility, also affects how profitable an option may be. If traders expect volatility, the option premium may be expensive. But, there is a fairly logical motive for more expensive options in these cases, as higher volatility means there is a higher chance of a stock moving past the strike price.
Are Options More Expensive At Open?
Sometimes, options may be more expensive at opening. But this is not a universal rule of thumb. Everything that happens after markets close still plays a role in the value, but would mainly influence the following opening price. Many individual traders may only respond to various influential events and happenings in the early stages of the market when trade volume is at its peak.
Are Options More Expensive Than Futures?
Futures contracts are less expensive than options on a broad scale, especially if the volatility is high since options contracts are pricier if fluctuations are drastic. Options may be more expensive sometimes, depending on various factors.
What Makes Stock Options Go Up?
Many events and influences affect the fluctuations in the stock market. This can range from just about any impactful or influential event within the world, economy, or industry. But, it ultimately comes down to supply and demand.
The value of stocks would increase according to how many people hold or sell. It will typically increase when more people are buying than selling. Those who own options will need to monitor volatility as the expiration date approaches. For options and underlying stocks or securities that expect high volatility, the premiums may be higher as higher profit is expected.
Stock prices that are relatively flat with little volatility will be cheaper to attain as a general rule. But the risk is that unless the stock or security experiences a surge in volatility, the value of that option will probably remain the same. This leaving little to no profit opportunity by the time of expiry.
Assessing the value of various options is undoubtedly perplexing, and it can be quite stressful without sufficient knowledge. When making such important decisions that will affect your livelihood, the best approach is to consult an option expert who can give valuable insight into which options would be best suited to your budget and trading goals.
Sources
https://www.investopedia.com/articles/optioninvestor/09/buying-options.asp
https://optionstradingbeginner.blogspot.com/2007/10/how-to-determine-if-option-is-cheap.html
