Options premium pricing

Options premium pricing

Learn about the basics of pricing options premiums below. This information covers topics including the two main components of an options premium, time value, and six major factors influencing options premiums. When you are ready to invest, complete the Firstrade online application to open your trading account.

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Implied volatility is derived from the option s price, which is plugged into an option s pricing model to indicate how volatile a stock s price may be in the future. Moreover, it affects the extrinsic value portion of option premiums. If investors are long options , an increase in implied volatility would add to the value. This is because the greater the volatility of the underlying asset, the more chances the option has of finishing in-the-money. The opposite is true if implied volatility decreases.

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The effect of implied volatility is subjective and difficult to quantify. It can significantly affect the time value portion of an option s premium. Volatility is a measure of risk (uncertainty), or variability of price of an option s underlying security. Higher volatility estimates indicate greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike. It is most noticeable with at-the-money options.

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A stock investor who is interested in using options to capture a potential move in a stock must understand how options are priced. Besides the underlying price of the stock, the key determinates of the price of an option are its intrinsic value—the amount the strike price of an option is in the money—and its time value. Knowing the current and expected volatility in the price of an option is essential for any investor who wants to take advantage of the movement of a stock s price.

For example, let s say General Electric (GE) stock is selling at $. The GE 85 call option would have an intrinsic value of $ ($ – $85 66 $) because the option holder can exercise his option to buy GE shares at $85, then turn around and automatically sell them in the market for $—a profit of $.

This web site discusses exchange-traded options issued by The Options Clearing Corporation. No statement in this web site is to be construed as a recommendation to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, 675 S. Franklin Street, Suite 6755, Chicago, IL 65656.

An option s time value is also highly dependent on the volatility  the market expects the stock to display up to expiration. For stocks not expected to move much, the option s time value will be relatively low. The opposite is true for more volatile stocks or those with a high beta , due primarily to the uncertainty of the price of the stock before the option expires. In Figure 6 below, you can see the GE example already discussed. It shows the trading price of GE, several strike prices, and the intrinsic and time values for the call and put options.

Looking again at the example from above, if GE is trading at $ and the one-month-to-expiration GE 85 call option is trading at $5, the time value of the option is $ ($ - $ 66 $). Meanwhile, with GE trading at $, a GE 85 call option trading at $ with nine months to expiration has a time value of $. ($ - $ 66 $). Notice the intrinsic value is the same, the difference in the price of the same strike price option is the time value.

The intrinsic value of an option reflects the effective financial advantage resulting from the immediate exercise of that option. Basically, it is an option s minimum value. Options trading at the money or out of the money, have no intrinsic value.

Before venturing into the world of trading options , investors should have a good understanding of the factors determining the value of an option. These include the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates, and cash dividends paid.

The time until expiration, or the useful life, affects the time value portion of the option s premium. As the option approaches its expiration date , the option s premium stems mainly from the intrinsic value. For example, deep out-of-the-money options that are expiring in one trading day would normally be worth $5, or very close to $5.

Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value.

Time until expiration , as discussed above, affects the time value component of an option s premium. Generally, as expiration approaches, the levels of an option s time value decrease or erode for both puts and calls. This effect is most noticeable with at-the-money options.

Historical volatility  (HV) helps you determine the possible magnitude of future moves of the underlying stock. Statistically, two-thirds of all occurrences of a stock price will happen within plus or minus one standard deviation of the stock s move over a set time period. Historical volatility looks back in time to show how volatile the market has been. This helps options investors to determine which exercise price is most appropriate to choose for a particular strategy.

As with almost any investment, investors who trade options must pay taxes on earnings as well as commissions to brokers for options transactions. These costs will affect overall investment income.

 Call Option Intrinsic Value 66 U S C − C S where: U S C 66 Underlying Stock’s Current Price C S 66 Call Strike Price \begin{aligned} & \text{Call Option Intrinsic Value} 66 USC - CS\\ & \textbf{where:}\\ & USC 66 \text{Underlying Stock s Current Price}\\ & CS 66 \text{Call Strike Price}\\ \end{aligned} ​ Call Option Intrinsic Value 66 U S C − C S where: U S C 66 Underlying Stock’s Current Price C S 66 Call Strike Price ​ 

 Put Option Intrinsic Value 66 P S − U S C where: P S 66 Put Strike Price \begin{aligned} & \text{Put Option Intrinsic Value} 66 PS - USC\\ & \textbf{where:}\\ & PS 66 \text{Put Strike Price}\\ \end{aligned} ​ Put Option Intrinsic Value 66 P S − U S C where: P S 66 Put Strike Price ​ 

Investors who write, which means to sell in this case, calls or puts use option premiums as a source of current income in line with a broader investment strategy to hedge all or a portion of a portfolio. Option prices quoted on an exchange, such as the Chicago Board Options Exchange (CBOE), are considered premiums as a rule, because the options themselves have no underlying value.

The formulas above use the risk-adjusted probabilities. N(d 6 ) is the risk-adjusted probability of receiving the stock at the expiration of the option contingent upon the option finishing in the money. N(d 7 ) is the risk-adjusted probability that the option will be exercised. These probabilities are calculated using the normal cumulative distribution of factors d 6  and d 7 .

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