- Jan 22, 2009
If the number of traders willing to buy an option at a given price is greater than the number of traders willing to sell the same option, the value of that option appreciates. It is the nature of the option markets to experience high demand of call options in a market that is in an uptrend and high demand of put options in a downtrend. Thus, it is not uncommon to see overpriced options in such scenarios. An interesting phenomenon in the equity indices, put options are almost always priced high to comparative calls. This is partly due to equity holders hedging their portfolios along with the expectation that markets drop faster than they go up. You may have heard the concept of higher put valuation referred to in the context of a "volatility smile" or "skewed volatility." In the case of equity indices the implied volatility of an at-the-money option is often less than that of an out-of-the-money option, or negatively skewed. This is especially true in the case of distant strike priced puts; interestingly, this didn't seem to be the case until after the crash of 1987.
If you are unfamiliar with the term implied volatility, it is important to note that the term differs greatly from market volatility (often referred to as historical volatility). Historical or market volatility is a direct measure of price movement, while implied volatility is a function of the derivative value (option premium) itself rather than the underlier. Therefore, options with differing strike prices or expiration dates but based on the same underlier may have differing levels of implied volatility. The formal definition of implied volatility is, in its simplest form, the volatility implied by the market price of the option
Another component of demand is strike price.
Strike price is obviously one of the biggest factors in the market's determination of option value. The closer to the money an option is, the more valuable it is to the buyer and the riskier it is to the seller. This makes sense; people are willing to pay more for an option that seems to have a better chance of paying out than they would for an option that will most likely expire worthless. As we cover in great detail throughout this book, the delta value of an at-the-money option is 50 and has roughly 50 percent odds of expiring in-the-money.