Why is the same amount of time value for some options more expensive than for other options?

Question

Thanks eric, but volatility is a two edged sword, it makes more gains possible, but also more losses. So the more volatile the stock, the time value should be cheaper? I'm confused.

Answer 1

In two words, implied volatility.

You need to understand the difference between historical volatility and implied volatility. Historical volatility is the actual amount of volatility the stock has demonstrated in recent trading. Implied volatility is the amount of volatility the stock will experience between the current time and the time the options expire in order for the options to be fairly priced. Implied volatility can be thought of as a market consensus of the amount of volatility expected.

Implied volatility is determined by supply and demand. If market makers get a lot more orders from people wanting to buy options on a particular stock than orders from people wanting to sell options on that stock, they increase implied volatility which in turn raises option prices. Similarly, if they get more orders from people wanting to sell options than from people wanting to buy options, they lower implied volatility and lower option prices. Market makers do this because they want to have roughly the same number of long options and short options in their portfolio. (The do not care if they are calls or puts.) If they get too overweighted with long positions or short positions they cannot hedge their risk as effectively.

Implied volatility does not always depend of historical volatility. A classic example of this is a small pharmaceutical company that has requested approval from the FDA to sell a new drug. From the time they request approval until they get a response from the FDA the stock is likely to have low volatility. However, everyone knows that a positive response form the FDA is likely to send the stock up 50% to 100% and a negative ruling is likely to send the stock down over 50%. Consequently implied volatility is sky high even though historical volatility is low.

One event that happens regularly which has a large impact on implied volatility is an earnings release. It is not uncommon for people to ask why a call option dropped in price even though the stock price went up following an earning report. The answer is that the implied volatility dropped.

Answer 2

In a word "volatility"

A more volatile stock will have a larger value for volatility when pricing an option and in turn a larger premium than less volatile stock for the same time period.

If you have a higher understanding of financial equations and much too much time on your hands check out the Black–Scholes formula for option valuation.

http://en.wikipedia.org/wiki/Black-Scholes