How to Price Options

by Beth Gaston Moon | April 12, 2012 2:17 pm

OptionsTradingBasics logo How to Price Options[1]At this point, you might be thinking: “Okay, I’m intrigued. But what kind of money should I expect to lay out to get into these option trades? And, more importantly, what kind of money do I stand to MAKE?”

The answers are, respectively, not a lot and potentially a LOT.

Much of the mystery surrounding options trading stems from the perceived difficulty in understanding all of the components. But once you realize it’s a science and you master it accordingly, then you can craft it into an art that works for you and your individual investment goals.

HOW TO TRADE OPTIONS:
- What Are Options?[2]
- What Are Options Contracts?[3]
- Price of Options[4]
- How to Read Options Symbols[5]
- How to Price Options[6]
- How to Read Options Quotes[7]
- Understanding Options Risk[8]
- Common Mistakes to Avoid[9]
- Options Trading Strategies[10]
- Choosing an Options Broker[11]

Although the price of an option is influenced by many factors, 90% of its price is based on:

• The stock price
• Time left until the option expires
• Volatility of the underlying stock

Below, we’ll look at each of those factors individually.

Stock Price

As already mentioned, the market price of the underlying security (be it the stock, index or exchange-traded fund- ETF) is where you start once you’ve identified the underlying asset on which you want to trade options. The stock price greatly — and perhaps predominantly — affects the price of the options available.

Let’s revisit Apple again. Suppose it’s trading at $525. Then the company introduces a product that’s even hotter than the iPad or iPhone, and the shares take off toward the $575 range with no signs of looking back. You’d better believe that folks will want to secure their right to buy shares at $525 (or any other strike price below the current stock price). As the stock price goes up, the call prices will go up in kind (and put prices will decrease). Contrarily, put prices rise (and call prices fall) as stocks move lower.

Time

Options are a wasting asset (i.e., they expire), so time erodes the value of all options. The further away the option is from expiration, the more value it likely could have. As the option approaches expiration, time decay accelerates because there’s less time for the option to move in the trader’s favor and into profitable territory. It’s useful to factor this into your options-trading decisions because you may want to buy options with more time (longer until expiration) than you think you may need to give the underlying stocks enough chance to make a positive change.

The chart below shows you how time erodes an option. If it’s May and you purchase a September option, then you’re giving yourself about five months for the option to move in your favor.

With a September option that’s purchased in May, there will be very little time decay in May, June and July. But as September approaches, the time decay speeds up, with the steepest decline occurring in the last 30 days before option expiration (which, again, is always effectively the third Friday of the month).

IP figure9 How to Price Options

Volatility

After the market price of the stock, volatility is the second-most important factor in determining an option’s price. Options on stocks that have been stable for years will be more predictably priced and, accordingly, priced lower than options on stocks whose charts are all over the place — up and down like a carousel horse gone amok.

History isn’t the only determining factor. Implied volatility also affects an option’s price because it’s based on the amount of volatility the market maker believes the stock is likely to experience in the future. A stock on the move will go up in price as more and more people want to get in on the action.

As the stock starts to move, the options market maker (the professional trader working on the floor) usually adjusts the implied volatility upward, which means the options premium will rise, even if all other factors (like the stock price) haven’t changed. The options will be worth more to investors who want to lock in a certain price at which they’d be willing to buy the stock.

Bid/Ask Prices

Every option (whether it’s a call or a put, expiring in a month or a year) always will have a “bid” and an “ask” price. Said simply, you buy at (or close to) the ask price and sell on (or near) the bid. For example, if you’re looking at November 75 Calls and you see prices of $8.60 X $8.90, then you’d be buying at the ask price (the higher price of $8.90) and selling at the bid price (the lower number of $8.60).

The difference between the bid and ask prices is called the “spread.” The narrower the spread, usually the better the liquidity (liquidity is the ability to move in and out of a position easily.)

IP figure10 How to Price Options

Endnotes:
  1. [Image]: http://investorplace.com/how-to-trade-options-options-trading-basics/
  2. What Are Options?: http://investorplace.com/2012/04/what-are-options/
  3. What Are Options Contracts?: http://investorplace.com/2012/04/what-are-options-contracts/
  4. Price of Options: http://investorplace.com/2012/04/price-of-options/
  5. How to Read Options Symbols: http://investorplace.com/2012/04/how-to-read-options-symbols/
  6. How to Price Options: http://investorplace.com/2012/04/how-to-price-options/
  7. How to Read Options Quotes: http://investorplace.com/2012/04/how-to-read-options-quotes/
  8. Understanding Options Risk: http://investorplace.com/2012/04/understanding-options-risk/
  9. Common Mistakes to Avoid: http://investorplace.com/2012/04/common-mistakes-to-avoid-when-trading-options/
  10. Options Trading Strategies: http://investorplace.com/2012/04/options-trading-strategies/
  11. Choosing an Options Broker: http://investorplace.com/2012/04/choosing-an-options-broker/

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