The Basics of Option Price Behavior

The subject of option price behavior requires two chapters to explain fully because traders must master two different aspects of option price behavior.This chapter discusses how option prices change as market conditions change. Option prices do not move in the short term the same way that stock prices and prices of futures contracts move. Traders therefore must learn to think in a different way when trading options.

The next chapter discusses the Greeks—delta, gamma, theta,vega, and rho—how they change, how they are used to evaluate position risk, and how position risk shifts as the market fluctuates.This chapter starts with a brief review of the analogy between options and insurance. Second, it describes how option values change as the various input factors change. Third, the subject of volatility and its impact on option prices is introduced.

The chapter concludes with a discussion of option price changes in a dynamic environment and the unique way that option traders plan trades.The Insurance Analogy:An option is like an insurance policy that pays its owner if certain events occur on or before the expiration date. If the events do not occur, the policy expires worthless.

The analogy between put options and insurance is perhaps easiest to understand. If the underlying stock declines in value, a put rises in value. The stock decline is similar to an insured asset being damaged,and the rise in put value is similar to an insurance policy paying a claim.Why calls are like insurance may be less obvious because a call contains a right to buy rather than a right to sell.

Nevertheless, calls are like insurance policies that insure participation in a price rise; they protect cash or liquid investments from missing a market rally. Puts insure against the risk of being in the market; calls insure against the risk of being out of the market. Puts limit risk from a price decline,and calls insure against missing a rally. Although one loss is a “real loss” and the other loss an “opportunity loss,” the put and call options that protect against these events are similar to insurance policies in every respect.

Components of Insurance Premiums:Insurance companies consider five factors when calculating premiums.They first look at the value of the asset being insured. If other factors are equal, the more valuable the asset, the more expensive it is to insure. The second factor is the deductible. The higher the deductible,the lower is the insurance premium because more of the risk is being born by the owner of the asset.

A policy’s term, or time to expiration, is the third factor. The longer the term, the higher is the insurance premium.The fourth factor is interest rates, which influence insurance premiums because insurance companies invest the premiums they receive until claims are paid. Rising interest rates cause insurance premiums to decline.The fifth and final factor is risk.

Many components contribute to risk, such as the nature of the asset and the history of loss in that class of assets. For example, a company insuring a car might analyze the age and driving record of the driver, where the car is parked, and how many miles per year it is driven. If other factors are equal, the higher the likelihood of damage to the car, the higher is the insurance premium.Insurance companies do not simply apply a mathematical formula
to these five factors to determine the premium for a particular policy.

They also consider what their competition is doing. Any difference between the market price of a policy and the company’s calculated theoretical value requires the insurance company to decide whether to “meet the competition” and do business or to hold back and wait for a better opportunity. Option traders also make such judgments all the time.

Options Compared to Insurance: Corresponding to the five components for insurance are six components for pricing options: the value of the underlying instrument,the strike price, the time to expiration, interest rates, dividends, and volatility. With options, the price of the underlying stock or index corresponds to asset value in insurance. If other factors are constant,a higher price for the underlying usually translates into a higher value for an option.

The distance between the current stock price and an option’s strike price corresponds to the deductible component in insurance. The deductible, remember, is the amount of risk borne by the insured party. An insurance policy with a $500 deductible, for example, means that a loss up to this level requires no payment from the insurance company. The same concept applies to options. An out-of-the-money option is like a policy with a deductible: The option pays nothing if the underlying stock does not move beyond the strike price, like an insurance policy expiring worthless.