Option Value and Pricing
How are Options Priced?
Finding Profitable Options to Trade
- What are Calls?
- What are Puts?
- Black Scholes Option Pricing Model
- Option Expiration Date
Definition of Option Value and Option Pricing:
The pricing of call options, like everything on Wall Street, is based on supply and demand created by the buyers and sellers of that option at that point in time. Beyond this simple supply and demand explanation of option pricing, you should also know that there are several formulas that Wall Street mathematicians have developed to approximate a fair price of call and put options. The most popular formula is called The Black Scholes Option Pricing Model. That Model is pretty complex, but what it says is the main factors affecting the price of options are the following:
- the difference between the strike price of the option and the current price of the underlying stock
- the number of days left until the option expires, and
- the expected volatility of the underlying stock.
Clearly the difference between the strike price and the current price is the most important factor. The right to buy Google (GOOG) at $700 when GOOG is at $600 should be worth less than the right to buy GOOG at $650. Likewise the right to by GOOG in 3 months at $650 should be worth more than the right to buy GOOG at the same price in 30 days. To the final point of volatility, since GOOG can easily fluctuate $10 in a day, the GOOG options should be priced more than the GE options whose stock price fluctuates 50 cents or less in a day.
Once you understand those 3 elements, then learn to start thinking of option prices as having 2 components. These are the "in-the-money" value (also called the intrinsic value) and the time value (also called the risk premium). A call option to buy AAPL at $335 when AAPL is trading at $340 is "in-the-money" $5 so you know the price will be at least $5. You might find this option to actually be trading at $6. That extra $1 is called the time value or risk premium and it represents the extra amount the market is willing to pay to basically bet the price of AAPL will continue to go up.
Understanding Pricing of Call Options: Let me explain the pricing of call options by walking you through the 3 bullet points above. First is the difference between the the strike price of the option and the underlying stock. I hope it is clear that if the AAPL stock is at $300 then the $310 call would be more expensive than the $320 call; and the $320 call would be more expensive than the $330 call, etc. Clearly there is a greater chance of the AAPL stock going up $10 than there is of the AAPL stock going up $20.
Take a look at the chart below which shows AAPL options for January and you will see that the call options with the lower strike prices are more expensive than the higher strike prices.
The second important factor that influences the price is the number of days left until the call or put expires. If today is January 1st and we are comparing the prices of the AAPL January $310 call to the February $310 call, then the January option has about 15 calendar days left and the February option has about 45 days left until expiration. We would expect to find the February options more expensive than the January options.
In the screen print above, we even see that the first option, a $305 call expiring Feb 04, 2011 is priced at $31.50 and the second option is also a $305 call expiring Feb 19th, 2011 is priced at $32.25. These extra 15 days are adding $0.75 to the price of the option.
The third important factor that influences the price is the expected volatility of the stock in the days remaining to expiration. Naturally, the prices of options on very volatile stocks are more expensive than the price of low volatility stocks. Stocks that move frequently move a couple of dollars a day (like Google) generally have expensive options compared to a stocks that only move a dime or two a day (like General Electric). On the topic of volatility, it is also important to note that the prices of options frequently get more expensive during the week of an expected earnings announcement and then return to normal the day after an earnings release. Why is this? Because the most volatile days for stocks are the days that earnings surprises are announced.
Call and Put Trading Tip: Actually, we are more concerned with trading days left than calendar days. Since the option markets are closed on the weekend and Holidays, the January options might have only 11 trading days left and the February options might have only 33 trading days left.
Logically, the February $310 call will be more expensive than the January $310 call, and the March $310 call will be more expensive than the February.
Here are the top 10 option concepts you should understand before making your first real trade: