The prices of options change in response to three main factors. The first is the price of the underlying. Delta and Gamma are used to estimate the change in an option’s price from movement. The second factor is the perceived risk. Implied Volatility (IV) measures the market’s risk level. The third factor is time and Theta is our measurement tool for time decay. One common observation is that when stock prices go down, especially when they go down hard, volatility increases. What can visualization techniques tells us about the movement of option prices relative to changes in the stock’s price and implied volatility over time?
A graph of the prices of the July 7th, 2016 expiration out-of-the-money strikes in SPY from the close of May 26 was displayed. The Volatility Skew to the put side stood out. The curve contains many details. The fatness of the curve indicates the level of IV and how likely the option will expire in-the-money (ITM). The curve enables us to visualize the information. We’ll look at three scenarios and see how the curve changes in response to all three. The different events are a month of quiet trading with not a lot of movement, a stock heading into an earnings announcement and a stock index before and after a large decline.
A graph was displayed of the option prices of JNJ. The stock had been relatively flat over a the period of time indicated and showed a small IV contraction. The OTM options decreased in value significantly while the at-the-money (ATM) options held their value. The next pair of curves was from GMCR going into an earnings announcement. Despite a large spike (55%-158%) in GMCR IV, option prices decreased. The third example is of prices in the SPX. Option prices increased from December 29, 2015 when the index was at 2075 and had an IV of 16% to January 20, 2016 when the index had declined to 1850 and IV had risen to 28%.
For more on related subjects see:
The Skinny On Options Math from April 16th, 2015: “Implied Volatility & Option Pricing”
The Skinny On Options Modeling from August 5th, 2015: “Deconstructing Option Prices to Isolate Volatility”
Market Measures from December 16th, 2015: “Visualizing Option Decay”
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of how option prices move over time in relation to different factors.
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