How do we know the whether the option is cheap or expensive?
The answer is in the IV. The premium of a contract is made up of two components
- Intrinsic value
- Time value
Intrinsic value is the amount the stock price is above/below the strike price for calls/puts. Intrinsic value is affected only by the move in the underlying price.
The value of the option premium above the intrinsic value is known as the time value. The two major factors which determine the time value are time to expiration and implied volatility (commonly known as IV or as vol.).
Implied volatility is the expectation of the future volatility in the underlying’s price. Higher IV indicates an expensive option and lower IV vice versa. The time value decays faster as we approach the expiration.
|Intrinsic Value = Stock Price – Strike Price||Intrinsic Value = Strike Price – Stock Price|
|Time Value = Option Price – Intrinsic Value||Time Value = Option Price – Intrinsic Value|
When should we be buying a Call/Put?
Long calls / puts are used to make profit from upward / downward moves in the price of the stock. The disadvantage of this trade is that the option will lose all the value due to time decay if the stock does not move up/down by expiry.
a) We should look to buy an option when the implied volatility is low and is expected to stay flat or rise. Since IV’s influence the premium we pay, the premiums will rise when the IV’s rise.
b) Once we enter a long option position we should look to sell it when in profits rather than wait for the expiration since time value comes into play.
c) We should avoid long options closer to expiry. Since options come with an expiration date, we should not be overexposed to time decay. The time value starts to decrease faster closer to the expiration date.
When should we be selling (writing) a Call/Put?
Selling a call/put is generally a bearish/bullish strategy where we expect the stock to be flat or move downwards/upwards. Selling options means we are taking unlimited risks for a limited reward.
a) When selling an option time decay will work in our favor.
b) If the implied volatility is also high the chances of the option premium correcting once the IV’s start falling is also high.
c) If the option is reasonably out of the money and we are close to expiry we should let the option expire as that would tend to give us maximum profits. However, we should exit the position when the underlying price starts to move in the opposite direction sharply.
In a Snapshot:
** Option premiums are made up of intrinsic value and time value.
** Time value is largely a function of Implied Volatility.
** Buy an option when the IV’s are cheap or are confident of the direction of movement in the underlying
** Write when the IV’s are high, time to expiration is approaching or are confident to no sharp movement in the underlying.