Implied Volatility and In-The-Money Options

Let's talk more about implied volatility.

A recent question I received touched upon the concept of in-the-money options and how, or if, they are affected by changes in implied volatility. It is a good question and one that deserves a little exploration here on the blog.

Below is a graphic, courtesy of ChartBender, that illustrates a key feature of in-the-money options. Each panel in the graphic reveals the value of a $35 XYZ call option.


Figure 1 assumes that our call option is worth $3 while XYZ is trading at $37 per share. Our $35 call option is $2.00 in-the-money. That means that the options has $1 worth of time value.

Intrinsic value is equal to the amount by which the option is in-the-money. It is not effected by implied volatility, the passage of time, the rise or fall of interest rates. It is simply equal to the amount by which the option is in-the-money.

When buying in-the-money options, it is worth noting that a portion of the option's value is comprised of intrinsic value. That intrinsic value is not effected by implied volatility. As a result, the overall price of the option is less vulnerable to changes in implied volatility.

However, prior to expiration, some portion of an in-the-money option will also consist of time value. In Figure 1, the option has $1.00 worth of time value. That time value can and will be effected by changes in implied volatility. If the option is comprised of a relatively small amount of time value, changes in implied volatility will probably have little effect, positive or negative.

In Figure 2, XYZ is trading at $36 per share. The option has lost $1.00 worth of its intrinsic value. However, the option price has only dropped from $3 to $2.25; a difference of just .75. The extra .25 is now comprised of additional time value. Since more than 50% of this in-the-money option's value consists of time value, implied volatility and theta decay will have a bigger impact upon it.

Figure 3 demonstrates an out-of-the-money contract. Naturally, there is no intrinsic value and the entirety of the option's $1.00 valuation is subject to changes in implied volatility.

It is time to start thinking about the significance of all this and how you might incorporate a better understanding of options pricing into your trading. Should you be buying in-the-money options? Are out-of-the-money options a better value? Does it depend upon whether implied volatility is relatively high or low?

We will talk more about this is later posts. In the meantime, do spend some time grappling with the issue and do feel free to jump onto our discussion board. If you have done so already, you may also want to take the time to watch a training video about using implied volatility to value options.


Good trading!

Christopher Smith
TheOptionClub.com