Options Pricing

Option premiums and the subsequent movement of option prices are determined through a pricing model such as Black-Scholes. Standard inputs of an options pricing model are:


Underlying Asset Price As detailed above, the relationship between the strike price and the underlying asset price will have a strong influence on the price of an option.

For a call option, the higher the underlying asset price, the higher the option premium. The payout at exercise of the option is the difference between the underlying asset price and the strike price. Call options with an underlying asset price below the strike are "out of the money", at the strike are "at the money", and above the strike are "in the money".

For a put option, the lower the underlying asset price, the higher the option premium. The payout at exercise of the option is the difference between the strike price and the underlying asset price. Put options with an underlying asset price above the strike are "out of the money", at the strike are "at the money", and below the strike are "in the money"

An option expiring today would be worth its "in the money" amount, or zero if the option was "at the money" or "out of the money". This is called Intrinsic Value.


The strike price represents the pre-determined price at which an option contract may be exercised, where a call buyer can buy the underlying asset or a put buyer can sell the underlying asset.

Consider a company whose share price is $32.90. An investor who expects the share price to rise is considering buying a call option at strike prices of $33.00 or $35.00. The investor expects the share price to rise within the following 90 days. The question the investor faces is what price should be paid for the rights conveyed by the call option.

The probability of the share price rising to the $33.00 strike is greater than the chance of the shares reaching $35.00. Therefore the premium cost for the $33.00 strike is higher than the premium cost of the $35.00 strike.

The opposite is true for put options, since they convey selling rights.

Interest Rate The rate of interest is a factor in determining the premium cost of an option. That's because investors are faced with an allocation choice between various assets including the risk free rate of interest on government securities. Investors tend to set the value in the calculator at the rate available on government bills for the period of the option, While the interest is a factor, its significance is fairly low.

Implied Volatility The greater the forecasted price movement, or implied volatility, the greater the probability that an option will increase in value. Therefore, the greater the implied volatility, the greater the option's price. Implied volatility does not suggest prices will go up or down, only that prices will move. Implied volatility is an estimate for the option contract period, and should not be confused with the historic volatility of the contract.

Time to Expiration An option that has time before expiration also has Extrinsic Value. The Extrinsic Value represents the probability that an option's underlying asset value will move in the future producing an increase in the Intrinsic Value. This The more time to expiration, the greater the probability that an underlying asset move will increase an option's Intrinsic Value. Therefore, for both Puts and Calls, the greater the time to expiration, the greater the Extrinsic Value. An options premium (or market value) is equal to its Intrinsic Value plus Extrinsic Value. At option expiration there is no Extrinsic Value remaining and so the Options Market Value will be equal to its Intrinsic Value.

Option Style American style options can be exercised at any point. European style options can only be exercised at expiration.

Dividends tend to affect an option price most when there are changes in the dividend amount and around ex-dividend dates.


Risks

The potential loss in a long call or long put is limited to the premium paid.


Conversely, the potential loss in a short call or short put is theoretically unlimited because it depends on how high the price can rise.


Different options can be traded simultaneously as part of a strategy (e.g. buying one call and one put on the same underlying).

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