For the novice investor, it’s understandable to assume that stocks with the same share price should have similar option prices, especially if those options expire at the same time.
But you’d be wrong. Option prices vary widely regardless of comparable stock prices, and today I’ll show you why.
At the time of this writing, both stocks were trading at $268.33 per share.
But let’s look at a sampling of option prices for each stock….
With each stock at $268.33, we’ll key on the January 2019 $270 call options, which are “at-the-money” (ATM). These are options contracts whose strike prices closely match the current stock price.
If you wanted to buy the $270 call option for each, you’d pay $15.75 and $19.05 per contract for Adobe and Nvidia, respectively.
Since each stock is equidistant from the $270 level, why would Nvidia’s call option cost $3.30more per contract? That’s roughly 21% higher.
Is there something wrong here?
Let’s dig a little deeper to find out.
To calculate an option’s price, you need six basic inputs:
1. Current stock price
2. Strike price
3. Expiration date
4. Level of volatility
5. Interest rates
The first four are the most important and have the biggest impact, while interest rates and dividends play a minor role.
So, if the first three inputs are exactly the same for both Adobe and Nvidia, then the level of volatility must be the culprit for the different option prices, right?
That’s exactly right!
The level of volatility is a statistical number that measures how erratic (or not) a stock price has been over a period in the past, and how erratic it’s expected to be in the future.
If a stock has been very erratic in the past, its volatility number will be much higher than a stock that has not been erratic in the past. What happened yesterday will likely happen tomorrow.
So, this must be the reason for the discrepancy in Adobe and Nvidia’s option prices.
The good thing is that we can look at volatility charts to see how the two stocks compare.
These aren’t stock charts – they are volatility charts that measure the fluctuations of each over a one-year timeframe.
The blue line measures past movements, called “historical volatility” (HV), and the orange line measures expected future movements, called “implied volatility” (IV).
Sometimes the past and future can vary widely, especially in the case of Adobe.
If you eyeball the yearly ranges, it gives you a clearer picture of an average level.
In my own trading, I tend to use the IV numbers because they’re an up-to-the-minute gauge of what the collective market thinks about a stock’s future movement.
In Adobe’s case, the one-year IV averages out to about 27% and Nvidia’s is roughly 40%. Even though Adobe’s chart has a bigger discrepancy between the HV and IV averages, Nvidia’s actual stock movement is still almost 50% moreerratic than Adobe’s.
If you look back at the stock charts linked above, you’ll see Nvidia has larger price swings and ranges than Adobe, even though they’re both moving in an upward trajectory.
In the world of options, the higher the volatility, the more expensive the options, and vice versa.
When plugging all these inputs into an option calculator, we can see the call option results.
You might notice one glaring discrepancy in the Nvidia calculations, though.
Although the $270 call-option value of $19.05 per contract roughly matches with the option chain above, it comes at a volatility level of just 32.6%.
That’s a lot lower than the 40% volatility we eyeballed in the chart.
Using 40% in the next calculator graphic yields a value for Nvidia’s $270 call option of $23.43 per contract. This makes its current marketplace value of $19.05 per contract seem well underpriced.
Which is correct?
Do you trust the one-year average of 40% or do you go with the current value of 32.6%?
Well, considering that the actual volatility of the stock has been trending lower (the HV/blue line), it’s probably safe to go with the 32.6%.
This is a lot of data! Have I made your head explode yet? Ha!
In the option’s world, I truly believe the more you know, the better trader you become. I’m here to help you do that.