How to Value Options

option valueThe value of an option, which is equal to the premium paid by the buyer of an option to the seller of an option, is comprised of both the intrinsic value and extrinsic value of the option.  The intrinsic value of an option reflects how far the option is in the money.

For example, for a call option, if the strike price of option XYZ is $10 and the price of the underlying security which the option is derived from is $15, the intrinsic value of the call option XYZ is $5 ($15 – $10). For a put option, if the strike price of option ABC is $15 and the underlying price of the security that the option is derived from is $10 than the intrinsic value of the option is $5.

The value of an option that is not intrinsic is extrinsic or time value.  If an option is out of the money, where the strike on a call option is above the current underlying price of the security, the entire value is considered time value.  For example, if call option CXYZ is trading at $1, while XYZ stock is trading at $15 and the strike price is $20, the value of the option CXYZ ($1) is time value.

Pricing an Option

The price of an option is determined by market participants who trade options in a fashion similar to stocks where supply and demand dictates the price.  Prices fluctuate on a daily basis based on market sentiment. In an effort to estimate the value of an option, traders often use options pricing models which value an option by calculating the premium based on a number of factors.

Factors affecting the price of an option

  • Price of the underlying security and its relative distance from the strike price
  • The strike price of the option
  • Time to maturity prior to the expiration of the option
  • Implied Volatility
  • Dividends (obviously only relevant for dividend paying securities)
  • Current Interest rates

Underlying Price and Strike Price

The price of the underlying security is key to valuing an option as it relates to a model how far the current price is relative to the strike price.  An option pricing model will add the intrinsic value to the time value calculated by using the difference between the strike price and the underlying price.  The further the option is in the money the great the value of the option.

For example, an option CABC that has an expiration date in 30 days and a strike price of $15 when the underlying price of $20 will have a greater value with all factor being equal than an option with a strike price of $18.

Time to Maturity

The time to maturity of an option measures how much time is left prior to the expiration of any option.  A longer time to maturity equates into a greater value for an option.  The reason this is the case is that with more time there is a greater chance in theory that an option will move in the money.

option time decay

Options are decaying instruments.  As seen in the chart, the passing of time erodes the price of an option.  At expiration an option can only have intrinsic value as the time value erodes to zero.

Implied Volatility

Implied volatility is the markets estimate of how much as security will move over a specific period on an annualized basis.  Implied volatility is quoted and referred to in percentage terms. Implied volatility is important because the value of an option is really based on the chance that the underlying price of a security will be in the money over a specific period of time.  For example, an implied volatility of 10% for a security that is priced at $20 means that investors expected the security to move to $22 or $18 within a year (10% * $20 = $2 ) ($20 + $2 = $22 or $20 – $2= $18)

The greater the implied volatility of an option, the better the chance that there will be significant movements in the underlying security increasing the likelihood that a security will move above the strike price in the case of a call, or below the strike price in the case of a put.

Implied volatility generally reflects the fear and greed associated with the market participants who are trading a specific security.  Higher implied volatility generally reflects fear of an adverse move in a security while lower implied volatility reflects complacency.

Dividends

Dividends are important for pricing option on stocks as the option value has to incorporate the fact that an investor can exercise the stock and receive the dividend by owning the stock.  Option sellers need to incorporate this value into the price of the option.  If the period the option is active does not cover an ex-dividend period, the dividend value does not need to be incorporated into the option value.

Interest rates

Current interest rates play a small role in the price of an option.  Interest rates calculate the time value of owning an asset.  The higher the interest rate, the more expensive it is to own an asset in the future.  The interest rate component is relatively small when compared to implied volatility or the current price of the underlying security relative to the strike price.

Options Pricing Models

The most popular options price model is the Black Scholes options pricing model created by Myron Scholes and Fisher Black in the 1970’s.  The Black–Scholes was first published by Fischer Black and Myron Scholes in their 1973 paper, “The Pricing of Options and Corporate Liabilities”, published in the Journal of Political Economy.

The model is a complex mathematical model, using the six inputs discussed in the article.  Since the introduction of the Black Scholes model there have been a number of iterations, as well as, alternative solutions, but most of the framework for pricing of options is derived from the Black Scholes model.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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