At the Intersection of Implied Volatility and Extrinsic Value
At the Intersection of Implied Volatility and Extrinsic Value
Option pricing requires this understanding of intrinsic vs. extrinsic value and time, as days-to-expiration
- Implied volatility and extrinsic value share a positive relationship, where if one goes up, the other goes up, and if one goes down, the other goes down.
- Option contracts should always be thought of as the option buyer buying the option contract from the option seller.
- Given the huge asymmetry of potential returns versus limited risk for the option buyer, the option seller will always increase the price of an option contract on a stock with higher volatility.
The relationship between implied volatility and extrinsic value is a fairly simple one, but the reasons behind the relationship might be a little less than obvious.
Plainly put, implied volatility and extrinsic value share a positive relationship. When one increases, the other also increases, and when one decreases the other also decreases. Since changes to extrinsic value drive changes to option prices themselves, volatility also shares the same positive relationship with option prices.
Easy enough—but why do volatility and extrinsic value behave in this way?
The best way to think of the option contract
To best answer this question, and any question related to option pricing for that matter, I think it’s always best to view the option contract as an agreement between the option buyer and option seller, where the option buyer effectively bought the contract from the option seller. In doing so, the option buyer has a contract with limited risk and essentially unlimited profit potential.
Similarly, the option seller now has a contract with limited profit potential and unlimited risk—a very unfavorable risk-return dynamic. Understanding these two sides of the contract, and the risks and returns associated with each, is the key to intuitively understanding the relationship between volatility and extrinsic value.
As an option buyer, given the fact that I can walk away from my contract at any time and simply be out the premium I paid for it (i.e., limited risk), I much prefer option contracts on stocks that are highly volatile, all other things being equal. While any added volatility might increase the likelihood that the stock moves against me, and I must absorb a loss, it also increases the likelihood that the stock moves for me, and potentially in a big way.
Given that there is such a significant asymmetry between my potential returns and limited risk, this tradeoff is favorable to me as the option buyer.
But higher volatility? Higher premiums
But remember, the option seller is on the other side of this trade, and as the potential returns to the buyer increase, the potential risks to the seller also increase.
So, what is the seller going to do to help protect himself against these added risks? The seller will effectively increase the price of the option contract on a more volatile underlying stock. Therefore, the option buyer must pay the option seller a higher premium on trade entry for the chance at a big win from all the added volatility, and thus, implied volatility and extrinsic value always exhibit a positive relationship.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.