Option Behavior

Options educational content provided courtesy of ChartBender.

Now that you're familiar with an option's anatomy, it's time to discuss an option's behavior. Here, in Option Behavior, we explain how implied volatility, time decay, and changes in the underlying stock price cause intrinsic value and time value to change.

In the next section, Decision Making, we provide some novel ideas on how to interpret the "cost and compensation" generated by implied volatility and time decay relative to the behavior of the stock price. This will put you on the road to making sophisticated and timely trading decisions.

As shown in the figure below, the time value of an option will erode or "decay" to nothing by the time the option reaches its expiration.

It's important to note that the decay of time value ACCELERATES as the option gets closer to expiring. So, an option with six months until expiration will decay much more slowly than an option with one month until expiration.

It's important to note that the decay of time value ACCELERATES as the option gets closer to expiring. So, an option with six months until expiration will decay much more slowly than an option with one month until expiration.

The fact that options with different expirations decay at different rates is a phenomenon on which a trader may try to capitalize. Click "See Example" below. Keep in mind that the forces of stock price movement and implied volatility must be considered, too.

Looking at figure 1 to the right, we see two at-the-money (ATM) options. Because these options are ATM, their prices are comprised only of time value. The Jan05 call option is green because all of that time value is going to be profit for you. Why? Because you are selling that option short and when you sell an option short, you want its value to decrease. And what happens to time value? It decays! That is, it decreases to nothing - exactly what you want from a short asset.

The May05 call option is red because you are long that option. When its time value erodes, it will generate losses. However, its time value will erode more slowly than the time value of the short option.

The ideal outcome is shown in figure 2. The yellow portion of each bar represents the amount of time value that has decayed from December 20th to January 21st. All of the short option's time value decayed (i.e., $1.25) while just $0.50 of the long option decayed. Thus, you made $1.25 on the short option and lost $0.50 on the long option for a net profit is $0.75.

Note: If you're wondering why you would bother to have the long option, the answer is for hedging purposes.

If the market expects a stock to be more volatile in the future, then the options for that stock will become more expensive today. In other words, an option's price "implies" the upcoming volatility of the underlying stock.

The more that a stock price fluctuates (i.e., the more volatile it is), the more likely it is that a given option on that stock goes in-the-money. This is why the expectation of higher volatility makes option prices more expensive. Likewise, when forthcoming volatility is expected to be low, option prices will deflate to reflect that outlook.

Looking at the figure to the left, you can see that the two option prices are different, even though the stock price is the same. The difference is due to the market's expectation of volatility for the underlying stock. In the left bar, the market's expectation is for lower upcoming volatility. The right bar reflects a higher expected degree of volatility. The amount of time value in each bar is indicative of the market's expectation for volatility.

Implied volatility is an attriube unique to options. It is very important to consider implied volatility in all of your trading decisions. ChartBender's iBoom application is an easy and powerful tool for helping you to consider implied volatility.

This educational content is provided by ChartBender.
© 2005 ChartBender, LLC.