Understanding option pricing and value is critical to becoming a successful trader. How can you know what something is worth (or what it could be worth) if you don’t know what factors go into its price?
Take gasoline prices for example. We all know that consumer demand, seasonal changes, crude oil prices, refinery productivity, state and local taxes, etc all affect the price you pay at the pump. At with prices nearly $4.00 per gallon lately, I’m sure you all are trying to squeeze more money out of each drop like I am…
Black Scholes Pricing Model
When buying or selling options, there is a system used in the market by which the market gives a price for any option. Most of the time it’s based on mathematical formulas like the Black Scholes model.
This is the most commonly used model in the market today and the formula looks like this:
Frankly it’s not important that you know exactly how to calculate it, but rather what variables go into the model. As any other finance professional will tell you, calculating this by hand back at the universities is painful and tedious but does help you understand what can affect option pricing.
Only 1 Variable Is “Estimated”
Six out of the seven factors used in valuing options are known, and the last – Volatility – is supposed to be an estimate. Of course this presents a big problem. Get the charts here.
Since volatility holds a lot of weight in valuing an option, and we always have to use an “estimate” it makes it impossible to calculate the true value of any option. More specifically, it’s the future volatility used in the model which makes it very hard price the option.
7 Factors That Determine An Option’s Price
1. Current Stock Price – Think logically here. If you interested in a call option that allows you to buy OEX stock at $390 per share, then you would naturally pay more for the call when the stock is trading near $390 as opposed to it trading at $410 right?
This is because the call option is now much closer to being ITM at $49 than it was if it was trading at $40. This works in the opposite for put options.
2. Strike Price – This is the price at which a call owner may purchase stock, and the put owner may sell stock. Like the example above, wouldn’t you pay more for the right to buy stock at say $380 than for the right to buy stock at $410?
Of course you would always prefer the right to buy stock at a lower price any day of the week! Thus, calls become more expensive as the strike price moves lower. Likewise, puts become more expensive in value as the strike price increases.
3. Type of Option – The value of an option depends on which type it is: Call or Put. Clearly there would be a difference depending on which side of the trade and market you are on. This probably is the easiest variable to understand.
4. Days Until Expiration – Options have a definitive life because of expiration. Therefore, an option will increase in value with more time. Why? Well, the more the time until expiration, the greater the probability or chance of a profitable move.
5. Interest Rates – This is really a small factor in determining an option’s price. When interest rates are on the rise, the value of call options rise as well. If a trader decides to buy a call option instead of stock, then the extra cash they have should theoretically earn interest for them. While this doesn’t necessarily work so easily in the “real world” the theory behind it does make sense.
6. Dividends – If a stock trades without giving the stockholder any dividend, it is said to be ex-dividend and its price goes down by the dividend amount. As dividend increases, puts are worth more while calls are worth less.
7. Volatility – The big variable right? In very simple terms, volatility measures the difference from day to day in a stocks price. I think of it as the “swings” that a stock has. Does it move back and forth violently or trading in a defined range with little daily movement?
Stocks that are volatile go through more frequent strike price levels than the non-volatile stocks. With these big moves, you have a higher chance of making money (i.e. moves outside the Blue area).
Thus an option on a volatile stock is much more expensive than one on a less volatile stock. Remember that even a small change in the volatility estimate can have a big impact on an options price.