Just finished the two options education days in Calgary and Edmonton. If you have not attended one of these, make sure to do so the next chance you get.

A number of great questions surfaced from the attendees. And I will make an effort to address some of these questions in future blogs.

One question that struck me over the weekend was related to the disparity between the volatility implied in the premium for in-the-money versus out-of-the-money options.

There are two components within an option premium; 1) time value and 2) intrinsic value. The latter being the in-the-money amount of the option. Time value being the options total premium less its intrinsic value. Volatility only impacts time premium.

To put some meat on this skeleton, let’s take a look at Suncor options. With the stock trading at $38.47 per share, the out-of-the-money Suncor June 40 calls are trading at $1.75 with an implied volatility of 44.36%. Note that the entire premium in the July 40 calls represents time premium and thus volatility has a significant impact on its price.

At the same time, the deep in-the-money Suncor June 24 calls are trading at $14.50 with $14.47 of intrinsic value and 3 cents of time value. The implied volatility is 78.50%.

On the surface, one might conclude that the Suncor June 24 calls were overvalued. But that conclusion assumes that deep in-the-money options actually trade like options. In reality, they don’t.

The deep in-the-money Suncor July 24 call will act more like a stock substitute, and will trade almost dollar for dollar with the underlying stock. Which means that the volatility assumption embedded in the contract has very little meaning.

In my opinion, you should ignore implied volatilities on deep in-the-money or deep out-of-the-money options. And pay particular attention to the implied volatility numbers on the close-to-the-money calls and puts.

These options have the most time value and act most like an option. As such, these volatility numbers are the best proxy as to the option markets’ best guess about future volatility in the underlying stock.