The Basics of Option Prices

Options trading can seem like a complex maze to the novice, but understanding how these financial instruments are priced is crucial for any investor looking to use them in their portfolio. An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price before a certain date. But what determines their price?

Options premiums aren't simply governed by supply and demand. Instead, they result from an interplay among several key factors, each pulling the price in different directions, including the underlying stock price and the time left until expiration.

Below, we'll break down the fundamental components of options pricing, making them accessible even to those who aren't math whizzes. By understanding these basics, you'll be better equipped to assess how and when to invest in options, along with the risks and rewards they offer. We'll also touch on the more sophisticated models experienced traders use with these investments.

Understanding the Basics of Option Prices

Options contracts provide the buyer or investor with the right, but not the obligation, to buy and sell an underlying security at a preset price, called the strike price. Options contracts have an expiration date or expiry and trade on options exchanges. Options contracts are derivatives because they derive their value from the price of the underlying security or stock.

A buyer of a call option would want the underlying stock price to be higher than the strike price of the option by expiry. Meanwhile, the buyer of a put option would want the underlying stock price to be below the put option strike price by the contract's expiry.

Many factors impact the value of an option's premium and, ultimately, the profitability of an options contract. We'll discuss two key components that comprise an option's premium, and whether it's profitable, that is, in the money (ITM), or unprofitable out of the money (OTM): intrinsic value and time value.

Pricing Call Options

Call options give the buyer the right to purchase the underlying asset at a specific price. Their value is primarily influenced by the following factors:

1. Stock price: As the stock price increases, call options become more valuable. The right to buy at a fixed price becomes more attractive as the market price rises. Delta is the options Greek that measures the sensitivity of an option's price to changes in the underlying asset's price. More precisely, delta shows how much the option's price is expected to change for every $1 movement in the underlying asset's price.
2. Strike price: Call options with lower strike prices are more valuable. They allow the holder to buy the stock at a lower price, potentially leading to higher profits.
3. Time to expiry: Generally, the more time left until expiration, the more valuable the call option. This is because there's more time for the stock price to move favorably. Theta is the options Greek that measures the rate of an option's time decay, giving you how much an option's price is expected to decrease as it nears expiration, assuming other factors stay the same.
4. Volatility: Higher volatility increases the value of call options. Wider price swings mean a higher chance the option will be profitable at some point before expiration. Vega is the options Greek that measures an option's price sensitivity to changes in the underlying asset's volatility. In particular, it reveals how much the price of an option is expected to change with a 1% change in implied volatility.
5. Interest rates: Higher interest rates will slightly increase call option values. This is because the cost of buying the stock outright (and forgoing interest on that money) is higher. Rho is the options Greek that measures the sensitivity of an option's price to a change in interest rates. An increase in interest rates will drive up call premiums and cause put premiums to decrease.
6. Dividends: Higher dividends typically decrease call option values. This is because dividends usually cause the stock price to drop, which is unfavorable for call holders.

Below is a chart that walks you through a scenario of how call options profits are affected by changes in the strike price (once they've already been priced and traded).

Pricing Put Options

Put options give the buyer the right to sell the underlying asset at a specific price. Their prices are influenced by similar factors as call options, but often in the opposite direction:

1. Stock price: As the stock price decreases, put options become more valuable. The right to sell at a fixed price becomes more attractive as the market price falls.
2. Strike price: Put options with higher strike prices are more valuable. They allow the holder to sell the stock at a higher price, potentially leading to higher profits.
3. Time to expiry: Like calls, puts generally become more valuable with more time until expiration. More time means more opportunity for the stock price to move favorably.
4. Volatility: Higher volatility also increases put option values. More significant price swings increase the chance the put will be profitable before expiration.
5. Interest rates: Higher interest rates slightly decrease put option values. This is because the opportunity cost of holding the stock (and earning interest on that money) is higher.
6. Dividends: Higher dividends typically increase put option values. This is because dividends usually cause the stock price to drop, which is favorable for put holders.

Below is a chart that walks you through a scenario of how put options profits are affected by changes in the strike price (once they've already been priced and traded).

Intrinsic Value of Options

The major driver of an option's premium is intrinsic value. This is how much of the premium is from the price difference between the current stock price and the strike price.

For example, suppose an investor owns a call option on a stock trading at $49 per share. The option's strike price is $45, and the option premium is $5. Because the stock price is currently $4 more than the option's strike price, $4 of the $5 premium is the intrinsic value.

For this stock, the investor would pay the $5 premium upfront and own a call option, which can be exercised to buy the stock at the $45 strike price. However, the option wouldn't be exercised until it's profitable or ITM.

You can determine how much the stock needs to move to be profitable by adding the premium price to the strike price: $5 + $45 = $50. The break-even point is $50, which means the stock must move above $50 before the investor can profit (excluding broker commissions).

In other words, to calculate how much of an option's premium is because of intrinsic value, you would subtract the strike price from the current stock price. Intrinsic value is important because if the option premium is primarily made up intrinsic value, the option's value and profitability are more dependent on movements in the underlying stock price. The rate at which a stock price fluctuates is called volatility.

Time Value of Options: Extrinsic Value

The time remaining until an option's expiration has a monetary value associated with it, which is known as time value. The more time remains before the option's expiry, the more time value is embedded in the option's premium.

In other words, time value is the portion of the premium above the intrinsic value that an option buyer pays for the privilege of owning the contract for a certain period. As a result, the time value is often called the option's extrinsic value.

Investors are willing to pay a higher premium for an option the longer it has remaining until expiration because there's more time to earn a profit. Nevertheless, the underlying stock price needs to move beyond the option's strike price to have intrinsic value. The more time that remains on the contract, the higher the probability the stock's price could move beyond the strike price and into profitability.

As a result, time value plays a significant role in determining an option's premium and the likelihood of the contract expiring ITM.

Time Decay

The time value decreases as the option expiration date approaches. The less time that remains on an option, the less incentive an investor has to pay the premium since there's less time to earn a profit. As the option's expiration date draws near, the probability of earning a profit becomes less likely, resulting in an increasing decline in time value. This process of declining time value is called time decay.

Typically, an options contract loses about one-third of its time value during the first half of its life. Time value decreases at an accelerating pace and eventually reaches zero as the option's expiration date draws near.

Measuring Time Value (Theta)

Time value is measured by the Greek letter theta. Option buyers must have good timing because theta eats away at the premium. A common mistake option investors make is allowing a profitable trade to sit long enough that theta cuts deeply into any potential profits.

For example, a trader may buy an option for $1 and see it increase to $5. Of the $5 premium, only $4 is intrinsic value. If the stock price doesn't move any further, the option premium will slowly degrade to $4 at expiry. A clear exit strategy should be set before buying any options.

Time and Volatility

The rate at which a stock's price fluctuates, called volatility, also influences the probability of an option expiring in the money. Implied volatility, or vega, can inflate the option premium if traders expect volatility.

Implied volatility is a measure of the market's view of the probability of a stock's price changing in value. High volatility increases the chance of a stock moving past the strike price, so options traders will demand a higher price for the options they sell.

This is why well-known events like earnings or acquisitions are often less profitable for option buyers than originally anticipated. While a big move in the stock may occur, option prices are usually high before such events, which offsets any potential gains.

Pricing Models for Options

While understanding the basic components of option pricing is crucial, experienced traders often use sophisticated mathematical models to calculate theoretical option prices. These models range from relatively simple to highly complex, each with its own strengths and uses.

The Black-Scholes model, developed in the 1970s, revolutionized options trading. It accounts for the current stock price, strike price, time until expiration, volatility, and risk-free interest rates to calculate a theoretical option price. While widely used, it has limitations, particularly for American-style options that can be exercised anytime before expiration.

Other models, like the binomial model, are more flexible for certain types of options. The binomial model uses a "tree" of possible future stock prices to calculate option values, making it particularly useful for American-style options.

As markets have evolved, more sophisticated models have been developed to account for various market conditions and option types. Here's an overview of some of the main option pricing models:

The choice of model depends on the specific type of option being priced, the characteristics of the underlying asset, and the market conditions.

For example, the Black-Scholes model is still widely used for its simplicity and efficiency in pricing European-style options. However, the stochastic volatility model might be more appropriate for options on assets with more volatile price shifts, like commodities.

While these models can offer a deeper understanding of options pricing, they are theoretical tools. Real-world option prices can deviate from model predictions because of market inefficiencies, market sentiment, and other factors not captured by the models.

For most individual investors, understanding the basic principles of option pricing is more important than trying to master these complex models. However, being aware of them and their applications can help you see how professional and more experienced traders approach this market.

The Bottom Line

Understanding option prices is crucial for any investor considering options trading. While intrinsic value and time value form the foundation of option pricing, more complex mathematical models can help you derive more precise and sophisticated options pricing analyses, especially around market volatility.

Option prices are constantly changing based on market conditions and time decay. Before diving into options trading, ensure you have a firm grasp of these pricing concepts and a clear strategy for entry and exit points.