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Options

Options Volume Is Not What It Seems

We talked recently about how new options terms and expiries have helped drive customer adoption and growth in options markets. We also saw that the most liquid options contracts also typically represent the most liquid stocks (and indexes) in the U.S. markets.

But when it comes to options, ADV (or contracts traded) is not all it seems.

Notional is different from contract values in options

In part, notional value in options works similarly to how stocks work. Low-priced stocks need to trade quite a few more shares to represent the same exposure.

For options, each one option contract represents one round lot, or 100 shares, of the underlying. That means one option in:

  • Ford (F), with a stock price around $12, represents underlying stock with a value of $1,200.
  • Apple (AAPL), with a stock price around $160, represents stock with a value of $16,000.
  • SPY, with a stock price around $400, represents underlying stock with a value of $40,000.
  • NDX, with an index price of $12,000, represents $1.2 million ($12,000 x 100) cash settled.

But that’s less than half the story.

First, an option is only “in the money” when the underlying is above (for a call) or below (for a put) the strike price. Consider the example below for a $25 strike call (and put). The dashed line represents the price of the underlying stock:

  • When the stock is worth $25 (dashed line crossing the axis) the puts and calls are “at the money” and have zero intrinsic value (the value any given option would have if it were exercised immediately) and a delta of around 50. So, we also see in the chart; both puts and calls have premiums that are positive at that point – thanks to their “optionality.” But the premium, at around $1, is far lower than the $25 price of the underlying stock.
  • As the stock price falls (the dashed line falls below the axis, that $25 call becomes out of the money (the strike is above the current stock price), and the option price falls too.
  • As the stock price rises (the dashed line rises above the axis), that $25 call becomes in the money. For every dollar the strike is below the current stock price, the intrinsic value of the option rises by a dollar. The option price rises too, but by less. Although when the stock reaches $30, the option price rises almost $1 for every $1 rise in the stock price (the “delta” of the option is close to 100). Even then, the intrinsic value of the option is still only around $5 ($30 stock - $25 strike price).

In short, even though in this instance $2,500 (100 x $25 underlying shares) worth of option contracts trade, usually far less actual economic exposuretrades.

Chart 1: Option premiums decline as the option moves further out of the money

Option premiums decline as the option moves further out of the money

The reason an “at-the-money” option has value is because, in the time remaining, there is a chance the option expires “in the money.” And that chance is reflected in the option’s price.

All other things equal, that “extrinsic value” is higher the more time an option has before expiring, as the more time you have, the larger an underlying stock’s returns can be. That’s something we also talked about in our first report on options. However, as Chart 2 shows, time value decays at different rates throughout an option’s life cycle. As you near expiration, time value (extrinsic value) starts to fall very quickly. If you’re writing (selling) a shorter dated option, this can add to the premium you can collect, which helps to explain the attractiveness of this practice. Another thing to note is that most novice traders buy more options than they write for potential levered gains (something we will cover more in the future).

Extrinsic value is higher months before expiry, but the total cost would be lower than purchasing options every week to do long-term portfolio hedges. In short, buying a one-year option might be cheaper than buying 12 separate one-month options.

Chart 2: Time value declines the closer you get to expiry

Time value declines the closer you get to expiry

Investors prefer out-of-the-money options

When we look at actual options trading data, we see that investors significantly prefer to trade out-of-the-money options (Chart 3). That’s important because from Chart 1, we see that the prices (option premiums) are lower, and with zero intrinsic value, much smaller hedges are required for the liquidity providers who hedge these contracts using stocks (or other instruments).

In the chart below, we see the contracts traded in the March QQQ options for the week of January 16 this year (around two months from expiry and for a short enough time that the time value was pretty constant). What we see is that:

  • The majority of calls (green area) are bought where the strike is above the current price range of the underlying (therefore, when traded, they are out of the money).
  • The majority of puts (red area) are bought where the strike is below the current price range of the underlying (therefore, when traded, they are also out of the money).

Chart 3: Histogram of puts and calls traded versus their underlying and options strike price (by “moneyness”)

Histogram of puts and calls traded versus their underlying and options strike price (by “moneyness”)

That also means the premium being spent (the economic exposure) and the delta (amount of hedging required by a market maker) are usually much lower than the value of contracts traded.

Premiums represent a fraction of what people call “notional”

We can see this most dramatically by comparing the contract value traded, the underlying market liquidity, and the premiums spent. This shows that although the options market trades contracts “worth” close to $650 billion each day:

  • The underlying stock market trades closer to $500 billion each day, with even more equity liquidity in futures.
  • The typical value of equity and ETF options premiums spent each day, which includes intrinsic plus extrinsic value, adds up to only $14 billion.

Chart 4: Comparing notional to premiums

Average daily values traded in 2023

Option ADV doesn’t say much (at all) about the actual economic exposures

Putting all this together, what we are starting to see is that some headlines about the scale of options trading, reaching close to $1 trillion, are just plain misleading.

The approximately $650 billion “value” traded represents what would happen if all options traded were in the money at expiration, which is impossible given most options traded are out of the money at the time of trade and options include both calls (stock higher) and puts (stock lower) to achieve this.

In fact, options premiums, representing both intrinsic and time value for options, are far lower – thanks again to the fact that most trading happens in out-of-the-money options with deltas often well below 50.

That means the actual hedging that market makers need to do in the real stock market — even assuming every options trade were fully delta hedged, which they aren’t, and sometimes hedged with other options or futures — is, in fact, a fraction of the $500 billion that trades in U.S. equities each day and is consistent with estimates we’ve made in the past.

Phil Mackintosh

Nasdaq

Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency. 

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