Last week was the worst week for the market in 2012. The S&P 500 fell by 2.4%. We were delighted to see our 10K Bear portfolio gain 24.2% for the week (10 times the percentage loss), once again demonstrating that a properly-executed options portfolio can provide a hedge against other investments that do best when the market moves higher.
This week we will take a step back and review the components that determine the value of an option. These components are the variables in most mathematical models designed to calculate the theoretical value that an option should be trading for, including the most popular Black-Scholes Model.
How Option Prices are Determined
Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices. Usually, they meet somewhere in the middle and a price is determined. This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.
There are 5 components that determine the value of an option:
1. The price of the underlying stock
2. The strike price of the option
3. The time until the option expires
4. The cost of money (interest rates less dividends, if any)
5. The volatility of the underlying stock
The first four components are easy to figure out. Each can precisely be measured. If they were the only components necessary, option pricing would be a no-brainer. Anyone who could add and subtract could figure it out to the penny.
The fifth component – volatility – is the wild card. It is where all the fun starts. Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company. Volatility is absolutely the most important (and elusive) ingredient of option prices.
Volatility is simply a measure of how much the stock fluctuates. So shouldn’t it be easy to figure out? It actually is easy to calculate, if you are content with looking backwards. The amount of fluctuation in the past is called historical volatility. It can be precisely measured, but of course it might be a little different each year.
So historical volatility gives market professionals an idea of what the volatility number should be. However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.
In future newsletters, we’ll continue this discussion of volatility and why it is the most important variable in option pricing.