An option is the right, but not the obligation, to buy or sell something at a fixed price within a certain time period. The right to buy something is called a “call option.” The right to sell something is called a “put option.” Options trade on almost all securities, including stocks, commodities, and bonds, and even on things that we don’t think about in technical terms such as airline reservations.
Whenever I purchase an airline ticket online a message pops up asking me if I want to purchase the right to cancel my reservation for a full refund. The airline is asking me if I want to purchase a put option. This example can be used to explain and demonstrate how option pricing works.
Let’s say that I am flying to Hawaii on April 1st. My ticket costs $800. For $50 the online reservation system offers me the option to cancel my trip at any time before my travel date for a full refund of the ticket price which I accept. In option pricing terminology, the $50 is called the option premium. I can sell my ticket back to the airline for $800 which is called the strike price. My option expiration date is April 1st, the date of my ticket.
How did the airline determine that the option premium should be $50? They had to figure out the probability of the option being “exercised” before April 1st, and their associated costs if I did cancel my ticket. I can guarantee you that they used some statistical expertise in calculating the premium.
The time until expiration of the option is a component of the price. If I were not flying until June 1st, the premium should be higher. The longer the time until an option expires, the higher the probability that an option will be exercised, and therefore, the higher the premium.
What if airfare prices have recently been extremely volatile? If I cancel my ticket and the airline has to resell my ticket, the higher the recent volatility of ticket prices, the higher probability that they will have to resell my ticket at a price lower than $800. Price volatility is component of option pricing.
In this case, I purchased an “at the money” option. I purchased the right to sell my ticket back to them at the current market price of the ticket which was $800. But what if they offered another strike price? What if they offered a premium of $25 to cancel the ticket and only receive a refund of $600? The market price verses the strike price is a component of option pricing.
In short, option premiums are a function of three primary things. The strike price versus the underlying security price; which is called intrinsic value. The time until the option expires; which is called time value. And “implied volatility” which is a measure of expected market volatility. Each component of an option’s price can be quantified individually.
Traders look to the implied volatility component in option prices as a gauge and forecast of future market movements. The VIX is a widely quoted and followed measure of implied volatility. The VIX is an index which represents the implied volatility of both put and call options on the S&P500 Index.
Because stocks tend to move upward at a measured pace, but fall in volatile fashion, the VIX usually spikes higher when stocks fall. The VIX is sometimes called “the market’s fear index.”
Leading up to the recent fall in price and surge in volatility of the S&P500, the VIX had been at historically low levels for an extended period of time. Exchanged traded funds and strategies which allowed traders to bet on a continued low volatility environment became very crowded trades. When the VIX finally spiked higher a couple weeks ago, those trades got crushed. One of the most popular of the “short-volatility” funds, XIV, fell from a price of $108, to a terminal value of $4. The unwinding of short-volatility trades is in itself a reason given for the recent market turmoil.
In conclusion, if and when you start to apply complex financial and statistical concepts to simple daily tasks such as buying an airline ticket, it’s probably time to take a vacation!
If you can’t afford a vacation, spend some time to learn and understand how option pricing and strategies work and how you can profit from them.