Intrinsic vs. Extrinsic Value

However, time value consists of time itself as an isolated impact on value (the closer to expiration, the more rapidly it declines). A second part of premium is extrinsic value, better known as implied volatility. Intrinsic value refers to the number of points in the money, and time value is a separate and depreciating form of premium. Intrinsic value is where all the variation takes place and where uncertainty is the primary attribute.

Intrinsic value most often tracks historic value closely, and for good reason. Options, it should be remembered, are derivatives, meaning the value is derived from the underlying. For this reason, historic value is a reliable test of option value and volatility. It is reflected in implied volatility (IV), but by itself, IV is of questionable value as a means for timing trades. It can be adjusted by changing the estimates and this itself means that IV cannot be used as a firm means for option pricing or for evaluating the true volatility.

Implied volatility often is given an assumed predictive quality. This is how options traders often use IV. But it is inaccurate to grant IV this value. When IV moves apart from historical volatility, it often indicates not a predictive move, but the mispricing of the option. This occurs for many reasons, but it is important to note that IV is questionable at best and inaccurate at worst. In comparison, realized volatility (movement in the underlying in response to perceived risk) is a more accurate predictive feature of the option:

Implied volatility is widely believed to be informationally superior to historical volatility, because it is the “market’s” forecast of future volatility. [But this is] a poor forecast of subsequent realized volatility … Implied volatility has virtually no correlation with future volatility, and it does not incorporate the information contained in recent observed volatility. [Canina, Linda & Figlawski, Stephen (1993). The informational content of implied volatility. The Review of Financial Studies 6(3(): 659-681]

The value of implied volatility is not disputed. But as an indicator of future pricing, it is not as reliable as many traders believe. Its most practical application is to make comparisons with historical volatility, whose historical and actual results are specific and accurate. When this is a method employed, it is easier to spot mispriced options than using any other method.

Variations and inconsistencies between historical and implied volatility are easily spotted by means of various technical signals, such as Bollinger Bands. This indicator tracks variation outside of the standard deviations of price based on short-term price averages. This is best known as a means for timing underlying trades, but it can also be effective in identifying when options are overbought or oversold. This greatly aids ibn the timing of short-term and speculative trades based on volatility levels. Implied volatility has great value when applied in this manner, but it is a mistake to rely solely on IV without also observing how the underlying is behaving.

The Bollinger Band-based test of historical volatility is expressed as price moves above or below two standard deviations from the average price. Its value is in how easily these volatility moves are seen on a chart. Options traders may immediately compare these moves above the upper band or below the lower band to option premium behavior. The approximate level of change should be similar. But when it is not (and notably when implied volatility is opposite the move in the underlying), traders have the advantage of being able to immediately exploit the mispriced option. These errors in p[ricing tend to self-correct rapidly, so immediate action is required to fully exploit the moment. This relies on the broad assumption that implied volatility has been calculated accurately, and this cannot always be known.

A solution to this potential inaccuracy is to limit the comparison. When an options trader follows the underlying and the option over a period and observes consistent correlation between historical ad implied volatility, it may be assumed that the calculation of UIV is reasonable. When the correlation begins to vary, that is the moment when assumed mispricing can be seen, and trades entered. They revert quickly, and they may perform in a manner equally volatile to the original mispricing, but the point remains valid: A change in correlation is a fair indicator of a mispriced option, but without the longer-term tracking of volatility, it should not be assumed that IV is always calculated accurately. As with all timing techniques, it is the change in correlation that adds meaning, not what is seen only in the moment.

Because option pricing may be affected by other influences than just volatility, the technique of timing for mispriced options relies on a belief that prices is fair and operating efficiently. Anyone who has operated in the market knows this is not always the case. The use of timing and correlation of volatility involves risk and markets are informally efficient, so options traders also need to keep an eye on influences beyond the option price and IV alone. This informational efficiency is a risk itself, because all information is given equal weight. This includes true and false information, rumor, gossip, and speculative belief. Markets are informationally efficient but the information itself may be less than accurate. This is a great flaw in the efficient market theory, and it has a direct impact on option pricing. It lacks economic efficiency, and that is what traders need to reduce market risk.

As levels of IV change, so does the calculation of future IV. This makes the test of pricing even more complex. Bottom line: Correlation is reliable even when IBV is not, and the comparison is the key to better timing of trades.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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