Today, I want to expand on time value and intrinsic value and begin describing how option prices change.
Those two components (intrinsic value and extrinsic value), together make up the option’s total value, the price at which we could buy or sell the option at any given time; but the two components change separately in response to three different main forces.
3 Forces That Affect Time Value and/or Intrinsic Value of Options
Changes in the actual current price of the underlying asset. This changes both intrinsic value and time value.
Changes in expectations for future movement in the price of the underlying asset. These changes affect time value only. Expectations for future movement, and therefore the time value portion of an option’s value, can change with or without any change in the actual current stock price.
Time decay. This also changes time value only, not intrinsic value.
First, the effect on intrinsic value:
The intrinsic value of an option as the difference between the stock price and the option strike price. For call options, it is the stock price minus the strike price; for puts it is the reverse, strike price minus stock price. For either puts or calls, if that calculation yields a negative number, then the intrinsic value of that option is zero (not negative). Below is a partial option chain for GLD, showing columns for Intrinsic and Extrinsic value:
Since a particular option’s strike price is fixed, the difference between its strike price and anything else can only change when the anything else changes. In other words, the intrinsic value of an option can only change when the underlying price changes.
Note, on the call side (left side) of the above option chain, the intrinsic value of the calls at the $123 strike is $.04. This is the difference between the stock price ($123.04, shown in the Last field of the header of the option chain) and the strike price of $123.00. In the line above that, for the strike price at $122.50, the difference is $.50 larger, so the intrinsic value is $.50 larger. Same again for the $122.00 strike: intrinsic value is another $.50 larger.
If the stock moved up by one dollar, the difference between that new one-dollar-higher stock price and each of these strike prices would then be a dollar more than it is now. And so, that one-dollar upward change in the stock price would result in the intrinsic value of each of these three options increasing by that same one dollar. Simple enough.
But note, the intrinsic value of the calls in the bottom three lines of the option chain, at the strike prices of $123.50, $124.00 and $124.50. For each of these calls, the intrinsic value is zero. This is because in each of these cases the intrinsic value calculation of stock price minus strike price yields a negative number. For all these options, intrinsic value is zero (it can’t be negative). These options are said to be out of the money, another term for having no intrinsic value. Those that do have intrinsic value are said to be in the money.
Let’s focus on the last line in the chain, the $124.50 call. If the stock were to rise by a dollar, from $123.04 to $124.04, then the call at the $124.50 strike would still have zero intrinsic value; the new $124.04 stock price would still be under the $124.50 strike price. So, the $124.50 strike call has zero intrinsic value now; and if the stock went up by a dollar, it would still have zero intrinsic value. For this option, the one dollar change in the stock price would not have changed its intrinsic value at all. This would be true of all calls with strike prices higher than $124.50 as well. All out-of-the-money options have zero intrinsic value, and that doesn’t change unless and until the stock moves enough to put them in the money.
This shows that for intrinsic value, there is what is called a threshold phenomenon; until it hits a certain threshold, which is the option’s strike price, changes in a stock’s price have no effect on the intrinsic value of the option, which remains at zero. But after that threshold is passed, then further stock price changes do have an effect. In fact, after hitting the threshold, the intrinsic value changes penny for penny as the stock price changes.
Let’s just digest that for a moment…
OK, moment’s up, time to move on.
We have now established that as the underlying stock price changes, there is no change in the intrinsic value of some of the options (the out-of-the-money ones), while there is a one-for-one change in the intrinsic value of other options (the in-the-money ones). As the stock price goes up, passing each strike price in turn, the call option at that strike, which was out of the money, suddenly finds itself in the money. It now has intrinsic value, which henceforth increases a penny for each additional penny the stock moves up.
If the stock drops, the process reverses. As the underlying drops past one strike price after another, the call at that strike, which was in the money, suddenly is out of the money again and bereft of intrinsic value.
It seems from this that the behavior of option prices should be very notchy, either remaining static or moving one-for-one with the stock. But this is not what happens. As the stock price changes, option prices change much more smoothly. They don’t just lie still and then abruptly move at full speed. Is our model of intrinsic value wrong?
No. The reason for the more-smooth movement is this: the changing price of the stock doesn’t only change the intrinsic value of an option. That stock price movement also directly changes the amount of time value. This has the effect of smoothing out the overall option price change caused by the underlying.
More on this next time, as we look into the way in which underlying price change affects time value.
Read the original article here - What Makes Option Prices Change?