by Matt Krupski

I have recently been asked how puts could lose value, even when the market sees a significant decline, or even an all-out crash. It’s important to understand all of the various factors that influence option pricing to see how this could occur.

Option prices are influenced by five major factors.

•    Time remaining until expiration
•    Costs of carry factors (interest rates/dividends)
•    Strike price
•    Price of the underlying
•    Expected (or implied) volatility of the underlying over the remaining length of the contract.

Given these five factors, option pricing models can calculate the value of an option. The first four of these factors are generally known. The wildcard is what the volatility will be over the remaining life of the contract. In general, the higher the expected volatility, the higher the price of the option, all else being equal.

Most market makers are not trying to actively guess the expected volatility in the future. Instead, they allow market forces to determine “fair value” of an option. By actively buying slightly below and selling slightly above this “fair value,” they make money. Market forces are the prime determinant of the implied volatility of the option, and as a result, their prices.

When the stock market starts to crash, more investors tend to buy options to protect their portfolio and to achieve market exposure, while avoiding the virtually limitless risk of futures. This increase in demand leads to an increase in the price of options.

The CBOE Market Volatility Index (VIX) measures the implied volatility of S&P 500 options. To derive this index, a basket of S&P options is examined, and given their pricing, the future, or “implied” volatility levels that are currently priced into the options are backed out. (Remember, four of the five factors in option pricing are all known, so given a price and an option pricing model, the implied volatility of the option can be derived).

So, S&P 500 option traders are wise to monitor the VIX.  A higher VIX means options prices in general are higher, while a lower VIX indicates more cheaply priced options.

Large initial market declines cause many investors to panic and buy options. Since the initial decline, people who needed to protect their portfolio would have already purchased their options, and everyone else becomes more accustomed to larger market swings. What this means for the individual holding put options is that all else being essentially the same (the strike price for your option hasn’t changed, the time until expiration is not that different, interest rates are the same, and if the underlying were in the exact same place as where you bought it), the value of your option will have declined.

There can be a situation where the market dropped a little bit from where it was when the options were purchased. This leads to a theoretical increase in the value of the option. Unfortunately, this increase can be offset by a decrease in the implied volatility of S&P options in general, and as a result, they can be trading at the same price as when an investor bought them.

Option pricing can be confusing, but hopefully the explanation is helpful. Please feel free to call me with any questions you have about the markets, and to develop strategies appropriate to your particular situation.

Matt Krupski is a Senior Market Strategist with Lind-Waldock. He can be reached at  877-847-3034 or via email at mkrupski@lind-waldock.com.

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