When it comes to pricing an Option, things can get tricky unless you first understand all the factors that go into determining an Options’ price. Only then will you understand why an Option does not move dollar for dollar with its underlying asset. But before we get to that, there are several factors to consider in the process:
Current stock price
Of course, the current price of the underlying asset has a direct influence on its option. However, the effect is not a 1:1 relationship, meaning a dollar increase in the stock price does not necessarily equal a dollar increase in the Option price. It typically goes that as a stock price increases, it’s likely that a call option will increase in value, while a put option falls.
This is the value of an Option if you exercised its rights today. Investopedia describes it as, “The amount by which the strike price of an option is in the money.” In other words, it can be seen as the minimum value of an option. Keep in mind, that any options at the money or out of the money will have no intrinsic value.
You can easily uncover the intrinsic value of an Option using one of the following two formulae:
Call Option Intrinsic Value = Underlying Stock\'s Current Price – Call Strike Price
Put Option Intrinsic Value = Put Strike Price – Underlying Stock\'s Current Price
Time to expiration
All Options – both calls and puts – have expiration dates. No Options are issued with rights that are valid for an indefinite period. This would make it too easy! Unfortunately, they all must come to an end at some point.
This portion of an Option’s price reflects the risk premium associated with it. It is the difference between the Option’s current price and its intrinsic value. This value is directly affected by an option’s time to expiration and the volatility of its stock.
This refers to the price movement of the underlying stock. When it comes to Options, volatility is treated the same way. Specifically, more price volatility in the underlying stock typically leads to a higher risk premium for the Option.
All of these five variables are used in one of the most popular Options pricing models introduced by Black and Scholes. Accordingly, it’s called the Black-Scholes Option Pricing Model (OPM). It allows you to find the price of option using all of the 5 variables discussed above. In addition, you will also need to know the relevant risk-free rate so you can use that in your calculation too.
Used correctly, stock options can increase your profit potential exponentially while also reducing your risk significantly. Our Elite Legacy Education trainers will introduce you to options basics and explain how you can control a stock for a fraction of its price, profit from stock you don't own, and make money when the price of a stock is barely moving at all.
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