When you are buying or selling an option, have you ever wonder how the option valuation is performed? How the option prices (premium) are calculated?
If you are not sure how stock option prices are derived, you may be overpaying it when you buy or may be selling it too cheaply.
There’s a certain formula that is used to calculate an option’s premium.
The market maker on the options exchanges use very precise software to price the options according to all the conditions that are known at that point of time.
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As a smart investor who inspires to have better trades in the options market, you need to get yourself familiar as to how option valuation is performed.
The price or “premium” of an option is dependent on the following 6 components. They are:
A) Underlying stock price
B) Strike price of the option
C) Time remaining until expiration
D) Volatility of the underlying stock
E) Current interest risk free rate
F) Dividend of the underlying stock
Options is a derivative security. Therefore the most important influence on a stock option price is the underlying stock’s price. When the stock option is deeply in or out of the money, the other 5 factors have little influence.
This means that when the options are deeply in the money, the option prices will almost have point-for-point price reaction with the stock price. When the options are deeply out of the money, the options may not react to any movement from the underlying stock price movement.
This is especially obvious in the last options expiration date. The option value is determined by the stock price and strike price on that day. The other factors have no effect at all.
A stock premium is make up of Intrinsic Value and Time Value. When the option is out of the money, the option price is mainly make up of time value. When the option is in the money, the option price is make up of both intrinsic value and time value. Therefore the price of an option will be higher when it is in the money and lower when it is out of the money.
As option is a “wasting” asset, the time value will slowly decay when it is nearer to the expiration date. When time to expiration goes shorter, the time value will drop lower and lower till zero value on the final day in the life of the option.
One important point to take note is that the time value of an option does not decay on a straight line basis. That is, it does not drop the same value every month.
An option’s time value decay much more rapidly in the last few weeks of its life then the first few weeks of its existence.
Volatility of the underlying stock is another important factor in the pricing of an option. More volatile stock have higher option price and less volatile stock has lesser option price.
This is because a volatile stock has the ability to travel a relatively long distance while a low volatile stock will not. Thus an option buyer is willing to pay more for a volatile stock’s option and an option seller would naturally demand a higher price as well.
Although cash dividend of the underlying stock is not considered as a major factor in option price, call option buyer (holder) of a low volatile stock should take note of the following example.
Eg. When a low volatile stock issues a dividend of $1 per share, the stock price will be reduced by $1 per share when it goes ex-dividend over that time period. As it is a low volatile stock, the stock price may not climb back to the original price after the ex-dividend reduction.
Therefore the call option buyer shall makes a lower bid as the underlying stock price will be reduced by the ex-dividend reduction, and the call holder does not receive the cash dividend.
One simple way to calculate the option valuation is to use an option pricing calculator.
Most of the options pricing calculator and software are using a formula know as Black-Scholes option pricing model.
This is name after the gentlemen that created it, Fischer Black and Myron Scholes.
You enter all the above 6 components into the pricing calculator and the calculator will produce a result that tell you what the options should theoretically cost. I say it is “Theoretically” as the price calculated might be quite different from the actual price of option trading at the exchange. The different is mainly cause by the volatility component.
The interplay between the 6 factors for option valuation can be quite complex. While a rising stock price may push the price of a call option up, the decreasing time will push the price to the other direction. Other factors such as the investor sentiment, result announcement and news can also play a part in determining the short term price fluctuation of an option.