What Is Option Pricing?

Pricing and Options

Before investors make a decision on going into trading options, they need to do some research and make sure that they understand what determines the value of each option. There are many of these factors including; intrinsic value; time to expiration; or the time value, volatility, interest rates and the cash dividends paid. These investors need to look into each one of these factors before deciding on specific trading options, and should choose the one that best suits what they are looking for.

Options are very similar to other investments that these investors make. Both need a good understanding of price determination so that they can take advantage of certain shifts in the market. Many options pricing models use these factors and determine the fair market value for the specific option.

What Are the Main Factors Driving the Price of an Option?

The first thing we need to look at is the primary drivers of the price of a specific option. These drivers would be the current stock price, intrinsic value, the time to expiration or time value, and volatility. The current stock price fairly obvious, but very important. The current stock price is constantly changing, and the changing of the price up or down directly changing the price of the specific option. Usually when the current stock price goes up, the call option will also go up and the price of a put option falls. Reversely, if the current stock price drops, so will the call and puts price.

What Exactly In Intrinsic Value

The value of a specific option if one were to price it today is known as the intrinsic value. More simply, the amount the strike price of an option is worth in cash. It is the part of the option’s price that is never lost as time passes on. There are a few equations that can be used to help calculate the intrinsic value of a call or put option:

The Time Value Equation

Time Value is the amount that a price of an option is greater than its intrinsic value, and is related directly to the amount of time an option has until it expires. It is also related to the volatility of the stock.

Stock Volatility

The time value of an option depends greatly on the volatility in the way that the market expects the specific stock will display up to its expiration. There are stocks that the market doesn’t expect to move much, for these the time value is low. The reverse is true for the stocks with high beta or volatile stocks. This is because the price of the stock before it expires is not certain. Effects of volatility are subjective and very hard to put an exact number on. There are; however, different calculators that can be used to help estimate the volatility.

The Bottom Line

If an investor is interested in using option pricing to obtain a potential move in a stock, that investor needs to understand exactly how these options are priced. The main way they are priced is the underlying price of the stock, but there are also other factors. One of the key factors of price is intrinsic value, or the amount by which the strike price of an option is in the money, the other is its time value. This is related to the amount of time an option has until it expires as well as its volatility. A stock trader should pay attention to the volatility if the wish to use these options to gain added advantage. If they look into the historical volatility it will provide them with a perspective on how it impacts this specific options price, while the current option pricing does provide implied volatility that the market will be expecting in the future.