Options Theory: Volatility Value
April 26, 2019
Last update: August 2021
Today I’m an advocate for a long-forgotten phrase that lost its fight for representation. To better understand the current situation you must first grasp the dynamics of options pricing. Allow me to bring you up to speed.
The Premium
The value or cost of an option is called premium. Many variables go into it. If you want a deep dive on the subject, I suggest starting here. For today, a shallow swim will suffice. Part of what drives the premium is intrinsic value, and the other part is extrinsic value. This is the base formula:
Premiums = intrinsic value + extrinsic value
Intrinsic value is defined as how much in-the-money (ITM) the option is. It is the reason why ITM options are so darn expensive. But it’s extrinsic value (EV) that demands our attention today. It is what you pay for time and volatility.
Extrinsic Value = time + volatility (EV deconstructed)
The more time remaining, the higher the extrinsic value. And, the higher the extrinsic value, the higher the premium. This is why 6-month options are more expensive than 1-month options.
We could also craft a similar statement with an emphasis on volatility. The more volatility expected, the higher the extrinsic value. This is why options on a high-octane stock like Advanced Micro Devices (AMD) are more expensive than a stodgy old staple stock like Proctor & Gamble (PG).
Which is more important? Time or volatility?
Marketing
Imagine the early days of options. The ’70s when sideburns and chest hair were in vogue, and bell-bottoms reigned. Options traders found it challenging to use the term “extrinsic value.” It was clunky and cryptic. So, a marketing campaign emerged to promote a synonym. One that rolled off the tongue and better represented what extrinsic value was all about.
Options enthusiasts quickly divided into two camps. One took the side of time, and the other volatility.
Posters were posted, and marches marched. Sweet sounding slogans proliferated. Time Trumps! Volatility Delivers!
Rallies were planned, and plans rallied around. It was a hotly contested battle with compelling arguments all around.
Twinners
Eventually, all the degenerate insult slingers realized something. Time and volatility are like conjoined twins. One can’t exist without the other, even if they want to. If in a fit of independence-seeking rage, one of them sawed their body in half to finally get some alone time – they would DIE.
Absent volatility, time is worth nothing.
Absent time, volatility is worth nothing.
Even if the stock ends up quadrupling over the next month (monster volatility!), it doesn’t matter to an option that expires immediately.
Even if an option has three years it doesn’t matter if the stock isn’t expected to move an inch.
In the end, time and volatility were found equally necessary. Both served as worth synonyms to extrinsic value.
But only one received the nomination. Maybe volatility wasn’t ambitious enough. Maybe time was an arrogant son-of-a-gun who demanded the spotlight.
Time boasted four letters and was easier to understand.
Volatility had a long name prone to misspelling.
Time won, volatility lost.
Today extrinsic and time value are used interchangeably. As for volatility value? He’s only used by kind-hearted chaps like me who like to give the underrepresented some well-deserved face time.
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Okay, that makes sense! Extrinsic value is not just time value. Both time and volatility are needed to make OTM options worth a tinker’s dam!
Indeed.
Hi Tyler,
Any chance you have an article or class on Intrinsic Value of a Stock. This is to be used to invest in stocks that have a good foundation and good Intrinsic Value. Im new and learning, any guidance will be of great help.
Thank you