Factors That Determine Option Pricing

Options can be used in a wide variety of strategies, from conservative to high risk. They can also be tailored to meet expectations that go beyond simple directional strategies. So, once you learn basic options terminology, it makes sense to investigate factors that affect an option's price in various scenarios.

Key Takeaways

  • Options are derivative contracts the right, but not the obligation, to buy (for a call option) or sell (for a put option) some asset at a pre-determined price on or before the contract expires.
  • Options can be used for directional strategies or to hedge against certain risks in the market.
  • Pricing an option relies on complex mathematical formulas, but the direct inputs into an option's price include the price of the underlying asset, the option's strike, time to expiration, interest rates, and implied volatility.

Using Options For Directional Strategies

When stock traders first begin using options, it is usually to purchase a call or a put for directional trading, in which they expect a stock will move in a particular direction. These traders may choose an option rather than the underlying stock due to limited risk, high reward potential, and less capital required to control the same number of shares.

If the outlook is positive (bullish), buying a call option creates the opportunity to share in the upside potential without having to risk more than a fraction of the market value. If bearish, buying a put lets the trader take advantage of a fall without the margin required to sell short.

Market Direction And Value

Many kinds of option strategies can be constructed but the position's success or failure depends on a thorough understanding of the two types of options: the put and the call. Furthermore, taking full advantage of options requires a new way of thinking because traders who think solely in terms of market direction miss all sorts of opportunities.

In addition to moving up or down, stocks can move sideways or trend modestly higher or lower for long periods of time. They can also make substantial moves up or down in price, then reverse direction and wind up back where they started. These kinds of price movements cause headaches for stock traders but give option traders the exclusive opportunity to make money even if the stock goes nowhere. Calendar spreads, straddles, strangles and butterflies highlight a few option strategies designed to profit in those types of situations.

Basics of Option Pricing

Option traders need to understand additional variables that affect an option's price and the complexity of choosing the right strategy. Once a stock trader becomes good at predicting the future price movement. They may believe it is an easy transition from options but this isn't true. Options traders must deal with three shifting parameters that affect the price: the price of the underlying security, time, and volatility. Changes in any or all of these variables affect the option's value.

Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to expiration) to theoretically value an option. Essentially, it provides an estimation of an option's fair value which traders incorporate into their strategies to maximize profits. Some commonly used models to value options are Black-Scholesbinomial option pricing, and Monte-Carlo simulation. These theories have wide margins for error due to deriving their values from other assets, usually the price of a company's common stock. There are mathematical formulas designed to compute the fair value of an option. The trader simply inputs known variables and gets an answer that describes what the option should be worth.

The primary goal of any option pricing model is to calculate the probability that an option will be exercised, or be in-the-money (ITM), at expiration. Underlying asset price (stock price), exercise pricevolatilityinterest rate, and time to expiration, which is the number of days between the calculation date and the option's exercise date, are commonly used variables that are input into mathematical models to derive an option's theoretical fair value.

Key Pricing Inputs

Here are the general effects that variables have on an option's price:

1. Underlying Price & Strike Price

The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value because you are able to buy the underlying asset at a lower price than where the market is, and puts should decrease. Likewise, put options should increase in value and calls should drop as the stock price falls, as the put holder gives the right to sell stock at prices above the falling market price.

That pre-determined price at which to buy or sell is called the option's strike price or exercise price. If the strike price allows you to buy or sell the underlying at a level which allows for an immediate profit buy disposing of that transaction in the open market, the option is in-the-money (for example a call to buy shares at $10 when the market price is currently $15, you can make an immediate $5 profit).

2. Time to Expiration

The effect of time is easy to conceptualize but takes experience before understanding its impact due to the expiration date. Time works in the stock trader's favor because good companies tend to rise over long periods of time. But time is the enemy of the buyer of the option because, if days pass without a significant change in the price of the underlying, the value of the option will decline. In addition, the value of an option will decline more rapidly as it approaches the expiration date. Conversely, that is good news for the option seller, who tries to benefit from time decay, especially during the final month when it occurs most rapidly.

3. Interest Rates

Like most other financial assets, options prices are influenced by prevailing interest rates, and are impacted by interest rate changes. Call option and put option premiums are impacted inversely as interest rates change: calls benefit from rising rates while puts lose value. The opposite is true when interest rates fall.

4. Volatility

The effect of volatility on an option's price is the hardest concept for beginners to understand. It relies on a measure called statistical (sometimes called historical) volatility, or SV for short, looking at past price movements of the stock over a given period of time.

Option pricing models require the trader to enter future volatility during the life of the option. Naturally, option traders don't really know what it will be and have to guess by working the pricing model "backwards". After all, the trader already knows the price at which the option is trading and can examine other variables including interest rates, dividends, and time left with a bit of research. As a result, the only missing number will be future volatility, which can be estimated from other inputs

These inputs form the core of implied volatility, a key measure used by option traders. It is called implied volatility (IV) because it allows traders to determine what they think future volatility is likely to be.

Traders use IV to gauge if options are cheap or expensive. You may hear option traders say that premium levels are high or that premium levels are low. What they really mean is that the current IV is high or low. Once understood, the trader can determine when it is a good time to buy options - because premiums are cheap - and when it is a good time to sell options - because they are expensive.

The Bottom Line

Options are complex, but their price can be described by just a handful of variables, most of which are known in advance. Only the volatility of the underlying asset remains a matter of estimation. Once you have a firm grasp of the essentials, you'll find that options provide flexibility to tailor the risk and reward of every trade to your individual strategies.

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