Options Pricing Explained
When you use options in trading, you will need to figure out what the instruments are worth to you.
Ultimately the prices will be decided in the marketplace, which is essentially an open auction where you will have to out-bid any other buyers or match any other offers if you want the right to buy or sell the security at the strike price you have in mind.
So what should the option be worth to you? It's important you think about all the factors involved in options pricing, because you can bet everyone else will be, and you don't want to lose money on your position without understanding why.
In a nutshell, there are six major factors which influence options premiums: 1.
Changes in the price of the underlying security.
An option is just a derivative, just a nebulous sort of possibility of what may happen...
that is, until it's in-the-money.
Then it can be exercised and effectively redeemed for the security itself, and therefore it gains intrinsic value.
So a call has intrinsic value if the underlying security is currently priced higher than the call's own strike price (it's in-the-money), and that intrinsic value is equal to the positive difference between the underlying security's price and the strike price of the call.
A put option is the opposite: it is in-the-money and has intrinsic value when the market is lower than the strike price.
When these options are in-the-money, their value will change penny for penny as the underlying security changes.
When they're still out-of-the-money, however, their premiums will change at only a fraction of the pace of the underlying security's changes.
2.
Strike price of the option itself.
As a list of call strike prices approaches and then moves above the underlying security's current price, the premiums for those calls will also move higher.
The opposite is true for puts: the lower the strike price, the greater the intrinsic value, and the higher the premium.
So the value of an option will depend greatly on how close its strike price is to being in-the-money, or how far in-the-money it is.
3.
Time until expiration.
If you were asked to make a bet that the Chicago Bears won't make it to the Superbowl next year, you might feel pretty confident.
But if you were asked to make a bet they would never make it to the Superbowl in the next thirty years - what a risk you'd be taking! The more time an underlying security has to move into in-the-money territory, the more risky it is to sell an option on that security, and the higher the premiums that will be offered.
Therefore, the time value of any option decays as the calendar date gets closer to the expiration date, but for out-of-the-money options, it's particularly pronounced.
When the option hits expiration out-of-the-money, it is totally worthless.
4.
Volatility of the underlying security.
People sometimes use options in trading to try to get away from the risk of the underlying security market's own volatility, but they must understand that same volatility impacts the premiums of the options.
The more volatile a market, the more likely it is to eventually move in-the-money or further in the money, and the higher the premium that will be demanded.
5.
Dividends.
Dividends affect options in trading much to same degree they affect the underlying security.
That market is mathematically expected to fall by the amount of the dividend on the day that dividend is paid.
So large dividends are bearish to a security during a certain point in time, and are therefore bearish to call premiums and bullish to put premiums.
6.
Risk-free interest rate.
Because options in trading require less cash up front (they're leveraged) than simply taking a position in the same number of securities, they are a good way for market participants to get exposure to the market without tying up a lot of money in a high interest rate environment.
In such an environment, a high risk-free interest rate will lead traders to highly value cash, and therefore highly value options (and raise their premiums), which allow them to save cash.
A low interest rate environment, on the other hand, has a smaller effect on option premiums.
Monitor all these factors during the time you hold an options position to manage your risk of losing premium money while you are using options in trading.
Some traders can make a fortune in options without ever touching a call or put that goes in-the-money, simply by taking advantage of those six factors.
Learn Option Trading Secrets That Most Other Option Traders Don't Know Exist!
Ultimately the prices will be decided in the marketplace, which is essentially an open auction where you will have to out-bid any other buyers or match any other offers if you want the right to buy or sell the security at the strike price you have in mind.
So what should the option be worth to you? It's important you think about all the factors involved in options pricing, because you can bet everyone else will be, and you don't want to lose money on your position without understanding why.
In a nutshell, there are six major factors which influence options premiums: 1.
Changes in the price of the underlying security.
An option is just a derivative, just a nebulous sort of possibility of what may happen...
that is, until it's in-the-money.
Then it can be exercised and effectively redeemed for the security itself, and therefore it gains intrinsic value.
So a call has intrinsic value if the underlying security is currently priced higher than the call's own strike price (it's in-the-money), and that intrinsic value is equal to the positive difference between the underlying security's price and the strike price of the call.
A put option is the opposite: it is in-the-money and has intrinsic value when the market is lower than the strike price.
When these options are in-the-money, their value will change penny for penny as the underlying security changes.
When they're still out-of-the-money, however, their premiums will change at only a fraction of the pace of the underlying security's changes.
2.
Strike price of the option itself.
As a list of call strike prices approaches and then moves above the underlying security's current price, the premiums for those calls will also move higher.
The opposite is true for puts: the lower the strike price, the greater the intrinsic value, and the higher the premium.
So the value of an option will depend greatly on how close its strike price is to being in-the-money, or how far in-the-money it is.
3.
Time until expiration.
If you were asked to make a bet that the Chicago Bears won't make it to the Superbowl next year, you might feel pretty confident.
But if you were asked to make a bet they would never make it to the Superbowl in the next thirty years - what a risk you'd be taking! The more time an underlying security has to move into in-the-money territory, the more risky it is to sell an option on that security, and the higher the premiums that will be offered.
Therefore, the time value of any option decays as the calendar date gets closer to the expiration date, but for out-of-the-money options, it's particularly pronounced.
When the option hits expiration out-of-the-money, it is totally worthless.
4.
Volatility of the underlying security.
People sometimes use options in trading to try to get away from the risk of the underlying security market's own volatility, but they must understand that same volatility impacts the premiums of the options.
The more volatile a market, the more likely it is to eventually move in-the-money or further in the money, and the higher the premium that will be demanded.
5.
Dividends.
Dividends affect options in trading much to same degree they affect the underlying security.
That market is mathematically expected to fall by the amount of the dividend on the day that dividend is paid.
So large dividends are bearish to a security during a certain point in time, and are therefore bearish to call premiums and bullish to put premiums.
6.
Risk-free interest rate.
Because options in trading require less cash up front (they're leveraged) than simply taking a position in the same number of securities, they are a good way for market participants to get exposure to the market without tying up a lot of money in a high interest rate environment.
In such an environment, a high risk-free interest rate will lead traders to highly value cash, and therefore highly value options (and raise their premiums), which allow them to save cash.
A low interest rate environment, on the other hand, has a smaller effect on option premiums.
Monitor all these factors during the time you hold an options position to manage your risk of losing premium money while you are using options in trading.
Some traders can make a fortune in options without ever touching a call or put that goes in-the-money, simply by taking advantage of those six factors.
Learn Option Trading Secrets That Most Other Option Traders Don't Know Exist!
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