Latest / How Canadian Markets Work / Episode 64: What Drives an Option's Price (Possibility as a Premium)

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Episode 64: What Drives an Option's Price (Possibility as a Premium) · How Canadian Markets Work

• 0:00
  Just take a moment to imagine holding a seemingly
• 0:04
  impossible financial puzzle right in your hands.
• 0:07
  OK, I'm picturing it. So you're looking at two
• 0:08
  options for the exact same stock. They have the
• 0:11
  exact same strike price. Right. And you are looking
• 0:13
  at them on the exact same day. The only difference,
• 0:15
  really, is that one expires next Friday, and
• 0:18
  the other expires, say, in nine months. Pretty
• 0:21
  massive difference. Exactly. Yet that nine month
• 0:23
  option costs several times more than the one
• 0:26
  week option. And you have to wonder. Why? Yeah,
• 0:29
  why pay all that extra premium? Right. And here
• 0:32
  is where it gets truly counterintuitive. How
• 0:36
  could you buy that nine month option, perfectly
• 0:39
  predict the direction the stock is going to move
• 0:41
  and still somehow lose your money? It really
• 0:44
  does sound like a riddle. But, you know, it's
• 0:45
  simply the reality of how the market prices a
• 0:48
  ghost. A ghost. I like that. Yeah, because when
• 0:51
  you buy an option, you aren't actually buying
• 0:53
  the underlying stock. You're buying the mathematical
• 0:56
  probability of a favorable outcome. Right. You're
• 0:59
  buying a chance. Exactly. You are paying for
• 1:01
  time. You are paying for chaos. And, well, if
• 1:05
  you don't fundamentally understand how those
• 1:07
  invisible forces are priced into the contract,
• 1:10
  the market will quietly bleed you dry. Even when
• 1:13
  your directional thesis is completely right.
• 1:15
  Even then, yes. Well, welcome to this deep dive.
• 1:18
  For you listening right now, we are going to
• 1:20
  look under the hood of options pricing. We really
• 1:23
  are getting into the plumbing today. We are.
• 1:26
  We're bypassing the basic definitions. You already
• 1:29
  know what calls and puts are. And we are going
• 1:31
  straight into the mechanics. Because we really
• 1:34
  need to understand how the market mathematically
• 1:36
  prices this concept of possibility. Yes. And
• 1:40
  why time itself is an active cost you pay every
• 1:42
  single day you hold one of these contracts. So
• 1:44
  let's start by cracking open that opening puzzle.
• 1:47
  The price disparity between the one week and
• 1:49
  the nine month option. Exactly. So understand
• 1:52
  that we basically have to split the premium right
• 1:54
  down the middle. We do. Because every auction
• 1:56
  price is constructed from two distinct components.
• 1:59
  You have your intrinsic value and your time value.
• 2:02
  Right. Let's start with intrinsic. So. Intrinsic
• 2:05
  value is the hard, tangible reality of the contract.
• 2:09
  It's simply what the option would be worth if
• 2:11
  you were forced to exercise it right this very
• 2:14
  second. Okay, so if I hold a call option with
• 2:16
  a strike of 50 and the stock is trading at 60...
• 2:20
  Your intrinsic value is $10. It's the built -in
• 2:23
  mathematical advantage you currently hold. Right.
• 2:25
  And the defining characteristic of intrinsic
• 2:27
  value, at least for the buyer, is that... It
• 2:30
  can never be negative, right? Never. Like, if
• 2:33
  the stock is at 40 and my call has a strike of
• 2:35
  50, I'm just out of the money. Exactly. My intrinsic
• 2:38
  value isn't negative 10, it's just zero. Because
• 2:41
  I hold the right, not the obligation, and I simply
• 2:44
  wouldn't exercise it. That floor of zero is so
• 2:47
  critical. An option with zero intrinsic value
• 2:51
  still trades for a premium on the open market.
• 2:54
  People still buy it. Right, because of that second
• 2:55
  component. Exactly. That residual price, everything
• 2:58
  charged above the intrinsic value is the time
• 3:00
  value. The time value. Yeah. When you strip away
• 3:04
  the immediate, tangible worth of the contract,
• 3:07
  the time value is essentially the market charging
• 3:10
  you for the chance that the world might change
• 3:12
  in your favor before the expiration date. It
• 3:14
  kind of makes me think of buying a lottery ticket.
• 3:17
  Oh, that's a perfect way to look at it. Like,
• 3:19
  if you buy a ticket where the drawing is tomorrow,
• 3:22
  you pay a certain amount. Right. But imagine
• 3:25
  buying a ticket where the drawing isn't for a
• 3:27
  full year, and during that entire year, the numbers
• 3:30
  are just constantly spinning. Just spinning and
• 3:33
  spinning. Yeah. You are paying a massive premium
• 3:36
  on that one -year ticket just for 12 long months
• 3:40
  of getting to wonder what if. You're buying the
• 3:42
  runway. You're buying the runway for a favorable
• 3:44
  outcome to arrive. Right. And that runway is
• 3:46
  entirely what dictates the cost. It is. And because
• 3:50
  this time value is the premium you pay for possibility,
• 3:53
  we really need to look at the specific variables
• 3:56
  that inflate or deflate that premium. The inputs.
• 3:59
  Right. There are five core inputs in standard
• 4:03
  options pricing models. You have the underlying
• 4:06
  price of the stock. the strike price you've selected,
• 4:08
  the time remaining to expire, the risk -free
• 4:10
  interest rate, and expected volatility. We could
• 4:15
  set interest rates aside for a moment, right?
• 4:17
  Yeah, they have a real effect known as row, but
• 4:20
  in the current macroeconomic environment, it's
• 4:22
  a minor driver compared to the heavy weights.
• 4:24
  Right. I really want to zero in on the third
• 4:26
  input, which is time, because the passage of
• 4:29
  time is just relentless. It really is. And the
• 4:32
  way the market models time decay, which is theta,
• 4:35
  It's not a flat linear slope, is it? Far from
• 4:38
  it. Time decay is an accelerating curve. Accelerating.
• 4:40
  OK, walk me through that. Well, if you buy an
• 4:42
  option with six months to go, the daily bleed
• 4:45
  of time value is practically negligible. A day
• 4:48
  passes, and you barely notice a drop in the premium.
• 4:50
  But as you get closer. Right. As you cross the
• 4:53
  threshold into the final few weeks, and especially
• 4:55
  in the final few days, the remaining time value
• 4:57
  drains almost by the hour. Wow. Yeah, the evaporation
• 5:01
  becomes violent. But why does it accelerate so
• 5:04
  aggressively? Like if a day is just a day, why
• 5:08
  does a Tuesday, three months from now, cost so
• 5:10
  much less than a Tuesday the week of expiration?
• 5:13
  It comes down to certainty. And really the narrowing
• 5:16
  of probability distributions. OK. Meaning what?
• 5:19
  Meaning when you have six months, a stock has
• 5:21
  the runway to make massive structural moves.
• 5:25
  Right. Anything can happen in six months. Exactly.
• 5:27
  But when you only have three days left, the statistical
• 5:29
  probability of the stock making a 30 % move drops
• 5:33
  to near zero. Right. The window is closing. The
• 5:36
  market knows this. As expiration approaches,
• 5:39
  the hope premium is rapidly, and I mean aggressively,
• 5:42
  priced out because the mathematical window for
• 5:44
  a miracle is closing. That makes sense. And this
• 5:47
  introduces a concept related to gamma risk. The
• 5:49
  closer you get to expiration, the more sensitive
• 5:51
  the option becomes to small moves in the underlying
• 5:54
  stock. So it becomes almost like a coin flip
• 5:55
  at the end. Yes. To compensate for that binary
• 5:59
  coin flip nature at the very end, the pure time
• 6:02
  value simply has to collapse. OK, let me just
• 6:05
  gently push back on how this feels for the buyer
• 6:07
  because this is where the theory actually hits
• 6:09
  your portfolio. Let's hear it. Say I buy a 90
• 6:12
  day option and the underlying stock just sits
• 6:15
  perfectly flat for 30 days. OK. Doing absolutely
• 6:18
  nothing, not trending up, not trending down.
• 6:21
  Have I actively lost money just by sitting there?
• 6:23
  You have lost money, yes. And that capital is
• 6:26
  permanently gone. Just gone. Just gone. The stock
• 6:29
  did absolutely nothing to hurt you directionally,
• 6:32
  and yet your position is bleeding. Wow. Because
• 6:35
  you bought 90 days of possibility and you consumed
• 6:37
  30 of them. Right. So the runway is shorter.
• 6:40
  The market continuously reprices your asset to
• 6:43
  reflect that your runway is now one -third shorter.
• 6:46
  So if the slow, relentless passage of time is
• 6:48
  constantly bleeding the buyer dry, the only way
• 6:51
  they survive is if the stock moves violently
• 6:54
  enough to outpace that decay. Exactly. They don't
• 6:56
  just need movement. They need chaos. Chaos. Which
• 7:00
  brings us to the fifth input. Expected volatility.
• 7:04
  Yes. If time decay is the absolute enemy of the
• 7:07
  option buyer, volatility is their greatest ally.
• 7:10
  And to understand why, we really have to look
• 7:13
  at the structural asymmetry of the contract itself.
• 7:16
  Right, because we established earlier that the
• 7:18
  intrinsic value stops at zero. Exactly. If I
• 7:21
  hold a call option and the stock completely collapses,
• 7:24
  my downside is strictly capped. That is your
• 7:27
  floor. Right. The absolute worst thing that can
• 7:29
  happen to me is that I lose the premium I paid
• 7:32
  upfront. I cannot lose a single penny more, even
• 7:35
  if the company goes bankrupt. But your upside
• 7:38
  is theoretically infinite. Because there's no
• 7:41
  ceiling on how high a stock can run. Right. And
• 7:43
  because you have this strict impenetrable floor
• 7:46
  and an infinite ceiling, wilder market moves
• 7:49
  only ever benefit you as a buyer. Because they
• 7:51
  can't hurt me past zero. Exactly. They can never
• 7:54
  hurt you proportionally. I mean, think about
• 7:56
  the math. If a stock drops 10%, your out -of
• 7:58
  -the -money option goes to zero. Right. If the
• 8:01
  stock drops 50%, your option still just goes
• 8:03
  to zero. You don't care how deep the basement
• 8:05
  is once you are standing safely on the ground
• 8:08
  floor. I really love that visual, standing safely
• 8:11
  on the ground floor. Yeah. But if a stock rises
• 8:14
  50%, your profits scale linearly and endlessly.
• 8:17
  Wait, but if I'm traditionally investing in a
• 8:19
  stock, I want stability, right? I want predictable,
• 8:24
  steady growth. Why am I suddenly paying a premium
• 8:27
  for an underlying asset that is behaving erratically?
• 8:30
  Because you aren't holding the asset. You are
• 8:32
  holding a highly leveraged directional bet. Right,
• 8:35
  right. Steady predictable growth is basically
• 8:38
  a death sentence for an option buyer because
• 8:40
  it rarely outpaces the aggressive slope of time
• 8:43
  decay. So you need it to swing. You need the
• 8:45
  stock to swing wildly enough to crash through
• 8:48
  your strike price and just keep going. And because
• 8:50
  of this dynamic, higher expected volatility mathematically
• 8:54
  raises the price of both calls and puts. Yes.
• 8:57
  The wider the potential variance of the stock,
• 9:00
  the higher the chance it swings through your
• 9:02
  infinite ceiling, while your floor remains perfectly
• 9:04
  intact. So the uncertainty is the value. Exactly.
• 9:07
  The more chaotic the environment, the more expensive
• 9:09
  the option becomes, completely regardless of
• 9:12
  which direction you are actually betting on.
• 9:14
  Wow. And that dynamic is exactly what sets up
• 9:18
  the most painful trap a retail investor can step
• 9:20
  into. Oh, absolutely. The mechanics of volatility
• 9:23
  explain why you can be perfectly right about
• 9:25
  a stock's direction and still suffer a devastating
• 9:28
  loss. The earnings trap. The earnings trap, yes.
• 9:31
  This is the scenario that answers our cold open
• 9:33
  perfectly. Let's walk through the anatomy of
• 9:36
  this trap for everyone listening. Let's do it.
• 9:38
  So a company is about to announce its quarterly
• 9:40
  earnings. The entire market knows the announcement
• 9:44
  is coming on Thursday after the bell. Right.
• 9:47
  And nobody knows if the guidance will be incredible
• 9:49
  or devastating. So because of that massive impending
• 9:53
  binary event, uncertainty is at a peak. Expected
• 9:57
  volatility is highly elevated. The market is
• 9:59
  basically pricing in the potential for a massive
• 10:02
  swing in either direction. And because volatility
• 10:04
  is a core input driving the premium, the options
• 10:07
  on this stock become incredibly bloated. Yes.
• 10:11
  The time value swells to account for the impending
• 10:13
  chaos. So you buy a call option hoping they announce
• 10:16
  a massive beat. You pay that bloated premium.
• 10:19
  Thursday afternoon arrives. Right. The earnings
• 10:21
  report drops and the news is fantastic. The company
• 10:25
  beat estimates, guidance is raised, and the underlying
• 10:28
  stock rises by 5%. You guessed the right direction.
• 10:32
  But then you check your brokerage account the
• 10:34
  next morning, expecting a windfall, and instead,
• 10:38
  your position is deeply in the red. You guessed
• 10:41
  right, and you lost. The stock moved in your
• 10:44
  favor, but the value of the option collapsed.
• 10:47
  How? Well, the mechanism at work here is driven
• 10:50
  by Vega, which is the metric that measures an
• 10:53
  option's sensitivity to implied volatility. OK.
• 10:56
  The moment that earnings report was released
• 10:58
  to the public, the mystery was over. The uncertainty
• 11:01
  was instantly and fully resolved. And because
• 11:04
  the uncertainty vanished, the market's expectation
• 11:07
  of future volatility completely collapsed. Yes.
• 11:11
  And when expected volatility collapses, the swollen
• 11:13
  time value of your option collapses right along
• 11:15
  with it. This is what the industry calls volatility
• 11:18
  crush. Exactly. Volatility crush. The underlying
• 11:20
  stock went up, which means your intrinsic value
• 11:23
  grew. Right. But because the binary event passed,
• 11:26
  the premium for possibility evaporated so fast
• 11:29
  and so violently that it completely eclipsed
• 11:32
  your directional gains. So you lost money. because
• 11:36
  the volatility drained out of the contract faster
• 11:38
  than the reality of the stock price could make
• 11:40
  up for it. A five percent move simply wasn't
• 11:42
  enough to overcome the deflation of the premium.
• 11:45
  It perfectly illustrates the burden of the options
• 11:47
  buyer to win. Being right eventually just isn't
• 11:52
  enough. It's not. Being right directionally isn't
• 11:55
  enough. You actually need three distinct things
• 11:57
  to align perfectly. You need the right direction,
• 11:59
  you need a massive magnitude of movement, and
• 12:02
  you need the timing to be absolutely precise.
• 12:04
  Yes. If you miss even one of those three variables,
• 12:07
  the mechanics of the contract, either through
• 12:09
  the slow bleed of time decay or the violent crush
• 12:11
  of volatility, will basically wipe you out. It
• 12:14
  is a steep uphill battle. The buyer is constantly
• 12:17
  fighting the math. Always fighting the math.
• 12:20
  Let's shift our focus a bit to how the market
• 12:23
  actually quantifies this chaos. We established
• 12:26
  that there are five inputs in the pricing model.
• 12:29
  And four of those inputs are hard verifiable
• 12:32
  facts. You can look at the ticker and see the
• 12:34
  stock price. You know your strike price. You
• 12:36
  know exactly how many days are left until expiry.
• 12:39
  Exactly. And you know the risk -free interest
• 12:42
  rate. But volatility isn't a fact, is it? No,
• 12:46
  it's a feeling. It's a forecast of the future.
• 12:50
  So how do we mathematically measure a ghost?
• 12:53
  Well, this is where the elegance of financial
• 12:55
  engineering comes in. Markets are brilliantly
• 12:58
  efficient machines for turning ghosts into math.
• 13:01
  Turning ghosts into math. I love that. Because
• 13:03
  we know the four hard facts and because we can
• 13:06
  observe the actual real -time trading price of
• 13:09
  the option on the open market, we don't have
• 13:10
  to guess the volatility. We can reverse engineer
• 13:13
  the pricing model. Exactly. We work backwards
• 13:16
  from the answer. Just the way you would solve
• 13:18
  an algebraic equation where you already know
• 13:20
  the solution but are missing one variable. So
• 13:22
  we take the Black School's model or a binomial
• 13:24
  pricing model and we plug in the current trading
• 13:27
  price of the option. Right. And the model then
• 13:30
  back calculates to figure out what level of expected
• 13:33
  volatility the market must be assuming to justify
• 13:36
  that specific dollar price. And this output is
• 13:40
  what we call implied volatility. Implied volatility.
• 13:43
  Four. It is the market's collective anxiety or
• 13:46
  collective greed distilled into a single highly
• 13:49
  actionable percentage. And the secret of the
• 13:52
  institutional auctions market is that professionals
• 13:55
  rarely think in terms of dollar prices, do they?
• 13:58
  No, not really. They don't look at a contract
• 14:00
  and debate whether $3 .50 is a fair price. They
• 14:03
  trade the implied volatility. They trade the
• 14:06
  IV? Yeah. They look at the IV percentage and
• 14:08
  compare it to the historical realized volatility
• 14:11
  of the stock. So if the market is implying a
• 14:13
  volatility of 40%, but the historical data suggests
• 14:17
  the stock rarely moves more than 20%, A professional
• 14:20
  will sell that option. They are betting that
• 14:22
  the market's fear is overpriced. They are entirely
• 14:26
  trading the ghost. Entirely. And that leads to
• 14:29
  a structural quirk in the market that honestly
• 14:31
  tells us so much about human nature. It really
• 14:33
  does. When you look at options on the broader
• 14:35
  market, like the S &P 500 contracts designed
• 14:38
  for downside protection, the put options almost
• 14:41
  always trade at much higher implied volatilities
• 14:44
  than equidistant call options, betting on an
• 14:48
  upward rise. The market consistently demands
• 14:50
  a higher premium to ensure against a drop than
• 14:53
  it does to speculate on a rally. This phenomenon
• 14:56
  is known as volatility skew. Volatility skew.
• 14:59
  But does that skew basically prove that investors
• 15:02
  are systematically more terrified of a market
• 15:04
  crash than they are excited about a market boom?
• 15:07
  Yes. Like is it just a mathematical footprint
• 15:09
  of fear being stronger than greed? It is deeply
• 15:12
  rooted in psychology, yes, but it is also rooted
• 15:15
  in the harsh mathematics of empirical market
• 15:18
  history. How so? Well, the original Black School's
• 15:21
  model assumed that stock returns followed a log
• 15:23
  -normal distribution, essentially a standard
• 15:25
  bell curve. Okay. In a perfect bell curve, a
• 15:28
  20 % drop is just as statistically likely as
• 15:30
  a 20 % gain, so puts and calls should technically
• 15:33
  be priced symmetrically. But the market doesn't
• 15:36
  operate on a perfect bell curve. It doesn't.
• 15:39
  Real world financial markets have what statisticians
• 15:42
  call fat tales. Fat tales. Extreme events, particularly
• 15:46
  on the downside, happen far more frequently than
• 15:49
  a standard bell curve predicts. Markets take
• 15:52
  the stairs up, but they take the elevator down.
• 15:55
  So panics are violent. Violent, correlated, and
• 15:58
  incredibly fast. So the market makers, the institutions
• 16:00
  actually selling these contracts, realize they
• 16:03
  were drastically underpricing the risk of a sudden
• 16:05
  crash. Exactly. The turning point was the 1987
• 16:09
  Black Monday crash. Oh, wow. Yeah. Before 1987,
• 16:14
  volatility skew barely existed. Options were
• 16:17
  priced relatively symmetrically. But when the
• 16:19
  market dropped over 20 percent in a single day,
• 16:22
  a move that the standard bell curve said should
• 16:24
  basically never happen, market makers were decimated.
• 16:27
  They realized the mathematical models were flawed.
• 16:29
  Because they didn't account for the fat tail
• 16:31
  of panic. So ever since then, market makers artificially
• 16:34
  inflate the volatility of out -of -the -money
• 16:37
  puts. They demand a massive premium for downside
• 16:39
  protection. Because they know that when the floor
• 16:41
  drops, it drops violently. So fear isn't just
• 16:44
  a feeling. It is an empirical risk factor that
• 16:48
  has been permanently coded into the pricing algorithm.
• 16:51
  It is a prominent scar on the market psychology,
• 16:54
  quantified in the volatility skew. We have dissected
• 16:57
  the anatomy of these contracts from every angle
• 16:59
  today. We've seen that an options price is fundamentally
• 17:01
  two things at once. Right. It is a ticking clock
• 17:04
  of time value, relentlessly decaying towards
• 17:07
  zero, and it is a real time thermometer of expected
• 17:10
  volatility, expanding in contracting with the
• 17:13
  market's collective uncertainty. The journey
• 17:15
  of the buyer is incredibly arduous. You are fighting
• 17:18
  theta decay. every single day. Every single day.
• 17:21
  You are fighting the sudden violent deflation
• 17:24
  of vega during a volatility crush and you are
• 17:26
  required to perfectly time a move of massive
• 17:29
  magnitude just to overcome the premium you paid
• 17:32
  for the privilege of the bet. Which leads to
• 17:35
  a final provocative thought to leave you with
• 17:37
  today. We spent this entire deep dive looking
• 17:39
  at the mechanics from the perspective of the
• 17:42
  buyer, the person paying the premium. Let's flip
• 17:44
  the chessboard completely upside down. Think
• 17:47
  about the entity on the other side of that trade.
• 17:50
  Think about the seller. The seller is operating
• 17:52
  in a completely inverted reality. If buying an
• 17:56
  option is brutally difficult. because you are
• 17:59
  constantly fighting the clock and fighting the
• 18:02
  crush of volatility, then the seller has all
• 18:04
  of those massive, invisible macroeconomic forces
• 18:08
  working quietly in their favor. Exactly. The
• 18:11
  seller acts as the insurance company. They collect
• 18:13
  the premium up front. And every day that passes
• 18:15
  where the stock does nothing. The seller captures
• 18:18
  that time decay. Theta is their daily income.
• 18:21
  And when volatility crushes after an earnings
• 18:23
  call. The seller captures that evaporated premium.
• 18:26
  Vega is the wind at their back. So selling options
• 18:28
  actually has a positive expectancy most of the
• 18:31
  time. The mathematical probability winning the
• 18:33
  trade strongly favors the seller. It does. You
• 18:36
  win a little bit of premium day after day, week
• 18:38
  after week as time decays and volatility reverts
• 18:41
  to the mean. The seller's risk profile is the
• 18:44
  exact inverse of the buyer's asymmetry. Right.
• 18:47
  Because remember, the buyer has a strict floor
• 18:49
  and an infinite ceiling. Which means the seller
• 18:52
  has a strict ceiling. They can only ever make
• 18:55
  the premium they collected. Yes. But they have
• 18:57
  an infinite floor. Their losses are theoretically
• 19:00
  unlimited if the stock moves violently against
• 19:02
  them. The buyer suffers a slow daily bleed, hoping
• 19:07
  for a miraculous infinite spike. The seller enjoys
• 19:10
  a slow daily drip of income living in the quiet
• 19:14
  terror of a rare infinite wipeout. It really
• 19:17
  forces you to ask a profound question about your
• 19:20
  own risk tolerance as you navigate these markets.
• 19:23
  Which side of that mathematical reality would
• 19:25
  you rather live on? The slow daily bleed of the
• 19:28
  buyer constantly paying for a miracle that rarely
• 19:31
  arrives. Or the terrifying invisible tail risk
• 19:34
  of the seller. peacefully collecting pennies
• 19:36
  on the train tracks, hoping they hear the whistle
• 19:38
  before it's too late. The mechanics of the market
• 19:41
  don't care which side you choose. They only demand
• 19:43
  that you understand the rules of the game you
• 19:45
  are playing. Exactly. Thank you for taking this
• 19:48
  journey with us today. Keep asking the hard questions
• 19:50
  for yourselves. Keep seeking out the why behind
• 19:53
  the market's plumbing. It makes all the difference.
• 19:55
  So the next time you look at two... identical
• 19:58
  contracts, and one costs drastically more for
• 20:00
  just a few extra months, you won't just see a
• 20:03
  price tag. You'll see the mathematical weight
• 20:05
  of time. You'll see the exact price of possibility.
• 20:08
  Take care of yourselves out there.