Index Option Pricing and Volatility

A payoff diagram is not a live valuation

Before expiration, an option can have time value in addition to intrinsic value. Its price responds to the underlying, remaining time, implied volatility and carry assumptions, including interest rates and expected dividends for equity indices. A final-payoff calculator cannot estimate every change in the option’s resale value during its life.

Volatility is a price of uncertainty

Implied volatility is inferred from option quotes using a model; realized volatility measures past movement. A buyer can lose even after predicting direction correctly if the move is too small, too late or accompanied by falling implied volatility. A quiet period does not establish that an upcoming event is cheap to insure.

Skew and expiry matter

Different strikes can imply different volatility, reflecting the market’s pricing of asymmetric risks. Expiries that span important announcements can be priced differently from those that end beforehand. Compare the same underlying, series and quote convention rather than treating one volatility number as a description of all options on an index.

Short-dated risk changes quickly

Near expiry, the option’s sensitivity can change rapidly as the underlying moves around the strike. A small premium does not necessarily mean a small risk for a seller. Use executable bid and ask prices when assessing costs; a model midpoint or historical mark is not a promise of an available trade.

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