Options are so strange

[lynx]

Hi Everyone,

There is an options question that I've had for a very long time that I've never quite been able to find a good answer to. I was hoping you might be able to help.

I hardly ever buy options, but sometimes I make a little money with them by buying puts or calls when I am convinced of an imminent move in a normally low volatility stock.

I fully understand the mechanics of how options work. I read a basic book on them many years ago, and it was utterly comprehensible.

I understand that options pricing is the sum of intrinsic value, recent volatility, time until expiration and supply and demand.

What I don't understand is why, everything else being held relatively constant, that the price of an option does not seem to track the price of the stock when the option is in the money and near the strike price. It moves much more slowly than the stock under those circumstances. I've observed this time and time again.

For example, I currently own an option with a strike price of 22.5 and an expiration of June. Over the last 3 weeks, the stock price has ranged between 22 and 23, currently at the high end. Volatility has increased slightly over that time. Yet the actual sales prices of the option has ranged only between about .60 and .85, roughly proportional to the stock price. I should mention that this is a thinly traded stock with even more thinly traded options.

I have see the same thing happen with more liquid issues as well.

Can anyone clue me in on why this happens? I'm sure it must have something to do with "greeks".

 

[JJacksET4]

Quote from lynx:

Hi Everyone,

There is an options question that I've had for a very long time that I've never quite been able to find a good answer to. I was hoping you might be able to help.

I hardly ever buy options, but sometimes I make a little money with them by buying puts or calls when I am convinced of an imminent move in a normally low volatility stock.

I fully understand the mechanics of how options work. I read a basic book on them many years ago, and it was utterly comprehensible.

I understand that options pricing is the sum of intrinsic value, recent volatility, time until expiration and supply and demand.

What I don't understand is why, everything else being held relatively constant, that the price of an option does not seem to track the price of the stock when the option is in the money and near the strike price. It moves much more slowly than the stock under those circumstances. I've observed this time and time again.

For example, I currently own an option with a strike price of 22.5 and an expiration of June. Over the last 3 weeks, the stock price has ranged between 22 and 23, currently at the high end. Volatility has increased slightly over that time. Yet the actual sales prices of the option has ranged only between about .60 and .85, roughly proportional to the stock price. I should mention that this is a thinly traded stock with even more thinly traded options.

I have see the same thing happen with more liquid issues as well.

Can anyone clue me in on why this happens? I'm sure it must have something to do with "greeks".

First of all, I think you are mistaking when you say .60-.85 range is roughly proportional to the stock price. 23 divided by 22 is a 4.5% difference - .85 divided by .60 is a 41.6% difference - almost 10 fold! The actual amount the option price moves may not be much, but it is the percent that makes the difference.

Also, there is a bid/ask spread which is almost certainly larger on the options then it is on the stock. So for example, if the stock was at 22.50 and the option bid/ask was say .65/.75, it would be easy for the stock to move up to say 22.70 and the bid/ask of the option to just change to .70/.75 or something. So the stock moves, but since the option is priced in "5"s it may not seem to change much on what is really a minor move for the stock.

Think about this - if a stock is at 22.50 and say the 22.50 strike call is about $125 - now the stock moves to 22.70, the option gains 20 cents of intrinsic value, but could actually lose a bit of time value (especially if this is over several days or a week or whatever). So the option might go up a bit to $130/135 range, but it could even stay the same - the IV might go down, but it's also partly the effect of the time running down a bit - remember that an option that currently expires in Jun only has so long and each week a reasonable portion of that is falling out.

JJacksET4

 

[lynx]

Quote from JJacksET4:

First of all, I think you are mistaking when you say .60-.85 range is roughly proportional to the stock price. 23 divided by 22 is a 4.5% difference - .85 divided by .60 is a 41.6% difference - almost 10 fold! The actual amount the option price moves may not be much, but it is the percent that makes the difference.
[/B]

Thank you for your response.

Proportional doesn't mean that they move the same amount (actual or percentage). It means that they track with a linear relationship, in this case, percentage x10.

However I did communicate badly, because what I was trying to say is that there did not seem to be a linear relationship after the stock went in the money.

The option price started moving very slowly or not at all once the stock went in the money, even accounting for time decay.

So for example, say the stock is at the strike on day 1, and the option is at .70. On day 2 the stock goes up to strike + 20 cents, but the option only goes to .75. There should be an extra .15 cents of intrinsic value in there, but it seems to be missing.

Then at some point well above the strike, the intrinsic value seems to catch up.

I've also seen this many times in the past with more liquid options with tighter spreads, thus my question, why does this happen?

 

[JJacksET4]

Quote from lynx:

Thank you for your response.
....
So for example, say the stock is at the strike on day 1, and the option is at .70. On day 2 the stock goes up to strike + 20 cents, but the option only goes to .75. There should be an extra .15 cents of intrinsic value in there, but it seems to be missing.

Then at some point well above the strike, the intrinsic value seems to catch up.

Yeah, basically what you are describing here is delta. Normally the delta for an ATM option is about .5, so as the stock moves, the option should move at half the rate of the stock. So in your example if the stock moves up 20 cents, the option should actually move up 10 cents. However, depending on the exact demand, etc. it is certainly possible it would only go up 5 cents. Also, delta is constantly changing as well, so an option with a .5 delta will not remain at a .5 delta as the stock starts to move. It will approach 1 if the options moves Deep in the money, or 0 if the option moves well out of the money.

Where you mention the intrinsic value catching up, you are seeing options where the delta is near 1. For example with a stock at 35, a 25 strike will be worth ~$1,000 - if the stock moves to 40 - it will now be ~$1,500.

JJacksET4

 

[lynx]

Thanks! By putting a name on it you've made it easier to google.

 

[nazzdack]

Quote from lynx:
----What I don't understand is....
----clue me in....
----something to do with "greeks".

1) FWIW, the stock may have a lot of covered-call writing taking place that seems to "pressure" the call option premium with respect to the stock price with the at-the-money strike price.
2) There can also be "rolling up" of call options from in-the-money and at-the-money strike prices up and out to out-of-the-money strike prices as the stock rallies that influences the respective premiums.

 

[lynx]

Quote from nazzdack:

1) FWIW, the stock may have a lot of covered-call writing taking place that seems to "pressure" the call option premium with respect to the stock price with the at-the-money strike price.
2) There can also be "rolling up" of call options from in-the-money and at-the-money strike prices up and out to out-of-the-money strike prices as the stock rallies that influences the respective premiums.

Very smart, now that you mention it, I think the covered call writing thing is precisely what is going on here.

 

[donnap]

Delta assumes that all other pricing factors are static. But the relationships are dynamic.

For example, delta may say that the option price change should be +.60. If the change is only +.40, then the .20 difference is attributed to a drop in IV - assuming all other pricing factors are static.

 

[spindr0]

Quote from lynx:

What I don't understand is why, everything else being held relatively constant, that the price of an option does not seem to track the price of the stock when the option is in the money and near the strike price. It moves much more slowly than the stock under those circumstances. I've observed this time and time again.

For example, I currently own an option with a strike price of 22.5 and an expiration of June. Over the last 3 weeks, the stock price has ranged between 22 and 23, currently at the high end. Volatility has increased slightly over that time. Yet the actual sales prices of the option has ranged only between about .60 and .85, roughly proportional to the stock price. I should mention that this is a thinly traded stock with even more thinly traded options.

There are a number of factors influencing what you are observing... or think you are observing:

Delta is the amount an option moves per $1 move in the underlying. It's a bit over .5 for an ATM call. More time remaining and higher implied volatility make delta even higher. So does a higher carry cost but that's neglible over the course of weeks.

You might see 10 BP of delta change b/t $22 and $23 so you might expect the ATM call to change 10 cts. However, other factors are affecting pricing:

Time decay is eating away at the premium ("...over the past 3 weeks")

B/A spreads can narrow and widen. If they're wide and you're not comparing bid to bid price change, option value may appear to change from trade to trade but it's really not changing at all..

Fluctuation of IV inflates and deflates premium

Last trade for option may not correlate with current price and that too may distort your perception.


The simple answer is that it's delta.

 

[spindr0]

Quote from donnap:

Delta assumes that all other pricing factors are static. But the relationships are dynamic.

For example, delta may say that the option price change should be +.60. If the change is only +.40, then the .20 difference is attributed to a drop in IV - assuming all other pricing factors are static.

Hey, that was pretty funny!
Can I fawn over you ???